Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
A forward contract, also referred to as a forward, is a type of customizable derivative contract between a buyer and a seller that sets the sale of an asset at a specific price on a specific future date. Like all derivatives, a forward contract is based on an underlying asset.
Forward contracts are similar to options, as discussed below, but there are some key differences that investors will need to know if they plan to use forwards as a part of their investing strategy.
Key Points
• A forward contract is a customizable derivative setting a specific price and date for an asset trade.
• Forwards are settled once at expiration, unlike daily-marked futures.
• These contracts are traded over-the-counter, offering flexibility but higher risk.
• Typically, no upfront payment is required to enter a forward contract (though some may include collateral requirements).
• Forward contracts are typically used by institutional investors due to high risks and lack of transparency.
How Do Forward Contracts Work?
Forwards are similar to options contracts in that they specify a price, amount, and expiration date for a trade. However, most options give traders the right, but not the obligation, to trade. With forward contracts, the transaction must take place at expiration.
Unlike futures contracts, another type of derivative, forwards are only settled once on their expiration date, but specific terms may vary based on the agreement between parties. The ability to customize forwards makes them popular with investors interested in self-directed investing, since the buyer and seller can set the exact terms they want for the contract.
Many other types of derivative contracts have predefined contract terms.
There are four main aspects and terms to understand and consider before entering into a forward contract. These components are:
• Asset: This refers to the underlying asset associated with the forward contract.
• Expiration Date: This is the date that the contract ends, and this is when the actual trade occurs between the buyer and seller. Traders will either settle the contract in cash or through the trade of the asset.
• Quantity: The forward contract will specify the number of units of the underlying asset subject to the transaction.
• Price: The contract will include the price per unit of the underlying asset, including the currency in which the transaction will take place.
Investors trade forwards over the counter, or OTC, instead of on centralized exchanges, which may make them less accessible to individual investors. Since the two parties custom-create the forwards, they may be more flexible than other types of financial products. However, they carry higher risk due to a lack of regulation and third party guarantee.
Recommended: What Are Over-the-Counter (OTC) Stocks?
What’s the Difference Between Forward and Futures Contracts?
Futures and forwards have many similarities in that they are both types of investments that specify a price, quantity, and date of a future transaction. However, there are some key differences for traders to know, including:
• Futures are standardized derivative contracts traded on centralized exchanges, while forwards are customized contracts created privately between two parties.
• Futures are settled through clearing houses, making them less risky and more guaranteed than forwards contracts, which are settled directly between the two parties. Parties involved in futures contracts almost never default on them.
• Futures are marked to market and settled daily, meaning that investors can buy and sell them whenever an exchange is open.
• Forwards are only settled on the expiration date. Because of this, forwards don’t usually include initial margins or maintenance margins like futures do.
• It’s more common for futures to be settled in cash, while forwards are often settled in the asset.
• The futures market is highly liquid, making it easy for investors to buy and sell whenever they want to, whereas the forwards market is far less liquid, adding additional risk.
Forward Contract Example
Let’s look at an example of a forward contract. If an agricultural company knows that in six months they will have one million bushels of wheat to sell, they may have concerns about changes in the price of wheat. If they think the price of wheat might decline in six months, they could enter into a forward contract with a financial institution that agrees to purchase the wheat for $5 per bushel in six months time in a cash settlement.
By the time of the expiration date, there are three possibilities for the wheat market:
1. The price per bushel is still $5. If the asset price hasn’t changed in six months, the contract may expire without a financial settlement.
2. The price per bushel has increased. Let’s say the price of wheat is now $5.20 per bushel. In this case, the agricultural producer must pay the financial institution $0.20 per bushel, the difference between the current market price and the price set in the contract, which was $5. The agricultural producer must pay $200,000.
3. The price per bushel has decreased. Let’s say the price is now $4.50. In this case, the financial institution must pay the agricultural producer the difference between the spot price and the contract price, which would be $500,000.
Pros and Cons of Trading Forwards
Forwards can be useful tools for traders, but they also come with risks and downsides.
Pros of Trading Forwards
There are several reasons that investors might choose to use a forward:
• Flexibility in the terms set by the contract
• Hedge against future losses
• Useful tool for speculation
• Large market
Cons of Trading Forwards
Investors who use forwards should be aware that there are risks involved with these financial products. Those include:
• Risky and unpredictable market
• Not as liquid as the futures market
• OTC trading means a higher chance of default and no third party guarantees or regulatory oversight
• Details of contracts in the market are not publicly available
• Contracts are only settled on the expiration date, making them riskier than futures contracts that are marked-to-market regularly
Who Uses Forward Contracts?
Typically, institutional investors and day traders use forwards more commonly than retail investors. That’s because the forwards market can be risky and unpredictable since traders create the contracts privately on a case-by-case basis. Often the public does not have access to the details of such agreements. Forward contracts are typically not accessible by retail investors; they are primarily used by institutional investors.
Institutional traders often use forwards to lock in exchange rates ahead of a planned international purchase. Traders might also buy and sell contracts themselves instead of waiting for the trade of the underlying asset.
Traders also use forwards to speculate on assets. For instance, if a trader thinks the price of an asset will increase in the future, they might enter into a long position in a forward contract to be able to buy the asset at the current lower price and sell it at the future higher price for a profit.
How Do Investors Use Forwards?
Traders use forwards to hedge against future losses and avoid price volatility by locking in a particular asset price or to speculate on the price of a particular asset, such as a currency, commodity, or stock. Forwards are not subject to daily price volatility. These strategies involve types of trades that aren’t typically available to individuals.
The trader buying a forward contract is taking a long position, and the trader selling is going into a short position. This is similar to options traders who buy calls and puts. The long position profits if the price of the underlying asset goes up, and the short position profits if it goes down.
Locking in a future price can be very helpful for traders, especially for assets that tend to be volatile such as currencies or commodities like oil, wheat, precious metals, or natural gas.
Recommended: Why Is It Risky to Invest in Commodities?
The Takeaway
Forward contracts are a common way for institutional investors to hedge against future volatility or reduce exposure to potential losses. However, they are generally considered high-risk investments that may not be suitable for most retail investors.
Given the specialized nature of forwards contracts (and other types of options), the risks may outweigh the potential rewards for many investors. As such, it may be a good idea to consult a financial professional before dabbling with forwards, or incorporating them into a larger investing strategy.
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Frequently Asked Questions
What is a forward contract in simple terms?
A forward contract is a private agreement between two parties to buy or sell an asset at a set price on a future date. These contracts are often used to hedge against price changes.
What is the difference between a forward and future contract?
Forwards are customizable contracts traded privately over the counter, while futures are standardized contracts traded on public exchanges. Futures typically have daily settlements and lower counterparty risk.
What are the benefits of a forward contract?
Forward contracts can help buyers and sellers lock in prices ahead of time, reducing exposure to market volatility. They also offer flexibility in terms and structure.
Do you pay to enter a forward contract?
Entering a forward contract usually doesn’t require an upfront payment. However, parties may face gains or losses at settlement depending on how the asset’s price changes over time.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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