In unpredictable markets, price changes can be extreme. By employing a forward contract, sellers and buyers have the ability to make agreements based on price for a specified date.
In doing so, buyers and sellers agree on a future price based on an agreement price made on the day the contract is entered. Volatility in the market can now be managed as prices have set points. This allows both parties to benefit from the decreased amount of risk.
How Does a Forward Contract Work?
A derivative is when a contract connects parties to assets. Forward contracts are just that, they allow buyers to take on a long position on the contract while the sellers take on a short position.
When forward contracts are agreed on, both parties must accept a set price. These prices are referred to as delivery prices, which must be accepted in order to begin trades. At the start of the contract, the delivery and forward price will be equal. In time, the forward price will begin to move while the delivery price is consistent.
With both parties using short and long positions, they have the ability to manage the volatility within the contract. Investors can use this competitive edge to hedge against risk to their assets. When the contract has reached its expiration date, if the contract price is different from the spot price-market exchange rate- the buyer or seller will need to pay the difference.
Forward Contracts in Simple Terms
Forwards contracts are privately negotiated, leading to all to be unregulated. Meaning, these contracts are non-transferable and are traded on the Over-The-Counter market. With asset values and exchange rates constantly changing, buyers and sellers are faced with a substantial amount of risk.
If there is little to no consistency in the markets, many sellers are not able to produce amounts needed for buyers. With more control over pricing, risk is easily managed by establishing target prices. Forward contracts enable businesses to project sales accurately, while protecting businesses from fluctuation in exchange rates.
Once a forward contract is created, a period of 12 months is given to transfer the amount agreed upon. With contracts being set unregulated by two parties, contracts are unable to be changed, unless by mutual agreement.
What Is an Example of a Forward Contract?
Let’s transition into understanding how these contracts work in real world examples.
In the case of a farmer selling beans to local shops, the farmer is informed that the price of beans will be dropping from $7 to $4 within the next few months. The bean farmer needs to make at least $5 per pound to stay in operation and make profit this year. The bean farmer decides to sell his beans to manufacturers at $6 per pound.
By implementing a forward contract with the manufacturers, the bean farmer benefits by locking into a price above the spot price. Because he is below the current spot price, he is ahead of the game before the drop in price. While the manufactures are below the current spot price and believe they are benefiting from a good deal at $6 per pound.
Do Forward Contracts Have Any Risks?
When entering into a forward contract, buyers and sellers understand the underlying risk they may face. The biggest risk these parties enter into are the inability to change the delivery price, unless mutually agreed on.
For example, if the bean farmer and manufacturers agreed on the $6 per pound contract and the spot price in the second quarter is now $4. The buyer is unable to change the terms of the contact to adhere to this price difference. The seller is now benefiting while the buyer is suffering from locking into a contract with a $2 high rate per pound.
With many factors affecting the value of assets, it’s not always easy to predict the spot price. This can cost firms a lot of money when the exchange rate doesn’t play in their favor.
Types of Forward Contracts
There are four versions of forward contracts available on the OTC market today.
With this contract in place, amounts agreed on are exchanged on a specified date with a set price. This form of forward contract protects the investor from fluctuations on the exchange rate. Businesses use outright forwards to lock into set prices to minimize risk.
While an outright forward requires parties to exchange agreed amounts by the end of the contract, flexible forwards allow for exchanges to be made before the end of the contract as well. There is a chance for buyers and sellers to set up multiple put-right payments or for payments to be made at the maturity date. With the wide range of flexibility, buyers and sellers can create contracts that best fit their business cash flow.
Enabling a non-deliverable forward allows parties to settle contracts without physical money. Buyers and sellers agree to only settle the difference each party endures. These contracts are entered to control the risk on business with limited funds.
What Is a Long-Dated Forward Contract?
Long-dated contracts are traded on periods longer than a year. By enabling these contracts, investors can hedge risk against traded currencies. There is a great amount of risk associated with these contracts. With many long dated contracts reaching beyond 10-years, risk of one party abandoning the contract.
What Is a Short-Dated Forward Contract?
Short dated contracts are used to trade currencies at predetermined set prices on a spot date. Companies use these contracts in order to hedge against risk on different currencies. These contracts are traded usually within weeks or months, because of this they tend to acquire less risk than long dated forwards. Investors find these are good to enter when exchanging international currencies
Why Would You Use Forward Contracts?
Businesses and individuals may find it beneficial to enter into these contracts to hedge against the uncertainty of the future. Large scale businesses may find this beneficial when the current exchange rate is low and their contracts are ready for renewal. While small businesses may find this beneficial from having smaller amounts of cash flow while scaling up.
Businesses also enter into these contracts because they are unregulated and therefore privately held. Without the disclosing of information to outsiders, a business can enter into contracts that they see to best fit their practices without outside interference.
Benefits & Disadvantages of Forward Contracts
Benefits of Forward Contracts
- Controlled exchange rates
- Risk from future drops/rises in market prices can be eliminated. By eliminating uncertainty in market prices, buyers and sellers can exchange goods while operating efficiently.
- Customized contracts
- With no regulation, contracts can satisfy the needs of buyers and sellers. Since the contracts are privately held, businesses can make decisions without the influences of outsiders.
Disadvantages of Forward Contracts
- Change in exchange rates
- Depending on the difference of spot price, the buyers may be spending too much for assets or vice versa, sellers may be selling assets below current market prices.
- Zero public trading
- With markets being privately held, no trading can be placed onto the contracts. These contracts have no liquidity on the OTC market.
Forward Contracts vs Future Contracts
Both forwards and futures contracts are based on the they have a few differences to keep in mind. While a forward contract is an agreement entered into by two parties to trade assets in the future on a specific date. A future contract is an agreement entered by two parties that settle daily until the specified end date on the contract.
A Plan in Uncertainty
With markets being unstable and extremely volatile, forward contracts are a great way to conduct business. Business being conducted today can seem extremely unpredictable, with many questions being asked like, where do I even start. Financial advisors are a great asset to use when determining your business goals.