Forward Contract - Meaning, How to Use, Examples, Types, Advantages & Risks

A forward contract is a financial agreement between a buyer and a seller to exchange an asset at a predetermined price on a specified future date. Due to their complexity, these contracts may not be suitable for the typical investor's portfolio. It is important to note that futures contracts and forward contracts are different financial instruments and should not be confused with one another. The following section provides a detailed explanation of each, along with an overview of their respective advantages and disadvantages for consideration.

What is a Forward Contract?

A Forward Contract is a type of financial agreement called a derivative. The value of a derivative depends on the price of something else, like a stock, commodity, or currency. Derivatives often involve two or more parties.

In a forward contract, the buyer agrees to purchase something at a set price in the future, so they take the "long" position. The seller agrees to sell it at that price, taking the "short" position. Both sides use the forward contract to reduce uncertainty by locking in the price of the item they are dealing with.

Examples of Forward Contract

For instance, a forward contract has been established between the buyer and the seller for the purchase of 100 kilograms of rice at a price of ₹40 per kilogram. The buyer anticipates that the market price of wheat will exceed ₹40 per kilogram at the time of contract execution. On the contract's settlement date, if the prevailing market price of rice is ₹42 per kilogram, the buyer stands to make a profit. By purchasing the rice at an agreed price of ₹40 per kg and then selling it at the market price of ₹ 42 per kg, the buyer would realize a profit of ₹2 per kg.

Types of Forward Contracts

Here are the main types of forward contracts:

1. Fixed-Price Forward Contract These contracts involve the agreement to buy or sell an asset at a fixed price at a future date. The price is agreed upon at the initiation of the contract and remains constant.
2. Open Forward Contract An open forward contract is a financial agreement between two parties to buy or sell an asset at a future date, without specifying an exact settlement time, leaving the contract open-ended. The price is determined at the initiation of the contract. It typically applies to currencies, commodities, or stocks.
3. Window Forward Contract A window forward contract allows the buyer or seller to settle the contract at any point within a defined period, rather than on a fixed future date. It offers flexibility, as the exact settlement time can be chosen within the window. It is useful in cases where the exact timing of the transaction is uncertain.

Why Implement Forward Contracts?

Entering into a forward market contract allows the seller to "lock in" the price of a specified asset, providing several advantages. This arrangement helps mitigate risk by ensuring that the seller can sell the commodity at the agreed-upon price, regardless of market fluctuations.

Similarly, signing a forward contract also enables the buyer to secure a fixed price, offering price certainty and protection against potential market volatility.

Features of a Forward Contract

Below are the top-notch features of a forward contract. These contracts are flexible and can be customized to meet the needs of both parties, including the asset, price, amount, and maturity date.

Risk management: Forwards can be used to manage risk, especially when businesses or investors want to protect themselves against price changes. By locking in a price for a future transaction, they can avoid unexpected price swings.

No upfront payment: There is no initial cost or margin requirement for forward contracts. The deal is settled when the contract matures. The price agreed upon in the contract is compared with the current market price, and the party that owes money pays the other party the difference.

Non-standard: Forward contracts are not standardized. The details of each contract vary based on the agreement between the two parties.

Counterparty risk: Since a forward contract is a private agreement, there is a risk that one of the parties may not fulfill their part of the deal. This risk can be reduced by checking the other party’s reliability, using collateral, or involving a middleman.

Liquidity: Unlike other financial contracts, forward contracts are not traded on exchanges, so it can be difficult to get out of a contract or change its terms before the maturity date.

Settlement: When the contract reaches its maturity date, the settlement happens. The difference between the agreed price and the market price is paid in cash or, if the contract calls for it, the asset is physically delivered.

Advantages of a Forward Contract

Here are five key advantages of a forward contract:

1. Customization

Forward contracts can be tailored to meet the specific needs of both parties. The terms, including the asset, amount, delivery date, and price, can be customized, unlike standardized contracts such as futures.

2. Hedge Against Price Fluctuations

Forward contracts are widely used to hedge against the risk of price volatility. For example, businesses can lock in a future price for commodities, currencies, or interest rates, ensuring more predictable cash flows and reducing the uncertainty of price movements.

3. No Initial Payment (No Premium)

Unlike option contracts, forward contracts do not require an upfront premium or margin payment. This makes them cost-effective to enter into since no initial capital is needed beyond the agreed-upon terms.

4. Flexibility

Forward contracts offer flexibility in terms of contract duration. They can be structured for a specific date or time frame, allowing the parties to align the contract with their own financial planning and risk management strategies.

5. Default Risk Protection

While risk exists for many businesses and individuals, a forward contract offers a more direct and flexible means of transacting compared to other alternatives, especially in situations where both parties are trusted and have a long-standing relationship.

These advantages make forward contracts useful for companies or investors who need a tailored solution to manage risk or lock in future prices.

Risks Involved in a Forward Contract

Forward contracts are commonly used to hedge against various risks, but they also come with several inherent risks. The key risks associated with forward contracts include:

Counterparty Risk: Since forward contracts are privately negotiated, there is a risk that one party may default on its obligations. If this occurs, the non-defaulting party may encounter difficulties in enforcing the terms of the contract.

Price Risk: Forward contracts expose both parties to price fluctuations. If the underlying asset’s price moves unfavorably relative to the contracted price, one party may incur a significant financial loss.

Liquidity Risk: Unlike exchange-traded instruments such as futures contracts, forward contracts do not have a liquid secondary market. As a result, exiting a forward contract before its maturity can be challenging, potentially leading to liquidity constraints.

These risks should be carefully considered when entering into forward contracts as part of a hedging strategy.

Difference Between the Forward and Future Contract

The key differences between futures and forward contracts are as follows:

Daily Settlement: Unlike forward contracts, which are settled in full at maturity, futures contracts are marked-to-market daily, with gains and losses realized on a day-to-day basis.

Exchange-Traded: Futures contracts are traded on organized exchanges, providing greater transparency and liquidity compared to the over-the-counter nature of forwards.

Standardization: Futures contracts are standardized in terms of contract size, expiration dates, and other terms, unlike forward contracts, which can be customized to the specific needs of the parties involved.

Conclusion
Forward contracts are widely used because they benefit both buyers and sellers. If you want to trade them too, it's important to understand how they work so you can make smart investment choices.