What Is a Forward Contract? (With FAQs and Helpful Examples)
A contract is a written or spoken agreement outlining the obligations of the involved parties. While you can negotiate contract terms to conduct transactions immediately, agreeing to forward contracts might better suit your financial or operational situation. Learning the definition of these contracts can help you negotiate better agreements with suppliers or customers. In this article, we explain what a forward contract is, discuss the types, differentiate these contracts from future contracts, explain why you might consider negotiating contracts, and show two examples.
What is a forward contract?
A forward contract is an agreement to sell or purchase an asset at a specified rate and future date. For example, you can make forward contracts with suppliers to purchase products at an agreed price by the year's end. Negotiating forward contracts can help you hedge or speculate. Hedging is the strategy of conducting transactions to reduce the risk of price changes in the future. For example, if you agree to sell a house at a specified price in the future, you may prevent the risk of increased housing prices.
Speculating is the strategy of engaging in transactions that may involve potential risks or rewards. For example, you might agree to purchase a stock at a set price in the future to make profits. Forward contracts are customizable, which means you can negotiate terms, such as product quantity, quality, price, and delivery date. Evaluating future agreements can help you determine whether suggesting this type of contract can benefit you.
Types of forward contracts
Here are various types of forward contracts you may negotiate:
Closed outright: This refers to a standard contract involving two parties completing a transaction at a set price and future date.
Flexible: Two parties can settle an agreement before the specified date by negotiating flexible forward contracts. This settlement may occur over one or multiple payments.
Long-dated: While many forward contracts last for a short period, long-dated ones typically have extended durations, such as a year or decade.
Non-deliverable: These forward contracts typically involve two parties settling their agreement in cash, considering the current and market price of the commodity or currency. It generally doesn't involve the physical exchange of products.
Forward contracts vs. future contracts
Forward and future contracts both involve a future transaction at a predetermined price. You can differentiate them by identifying when settlements occur. Unlike forward contracts that settle at maturity, you typically settle future contracts daily. For example, if you negotiate a future contract as a buyer, you typically fulfill your obligations until the contract ends. Alternatively, if you negotiate forward contracts, you can expect to fulfill your obligations only at the contract's end.
Determining whether you can trade a contract is another way to differentiate forward and future contracts. Forward contracts are typically private agreements that don't trade in a public exchange, unlike future contracts. This implies that a regulatory body called a clearinghouse typically oversees future contracts. A clearinghouse is a designated intermediary between a buyer and a seller in a financial market.
Why consider forward contracts?
Effective planning can help ensure forward contracts are beneficial and reduce the risk of defaults. Aside from hedging and speculating, here are other reasons for establishing this type of agreement:
You can negotiate forward contracts to secure a supplier in advance. You may also use these contracts to better organize product delivery. For example, suppose you want to buy chairs from a supplier and padded seats from another vendor. Because accepting both products at once might impact the supply chain team, you may negotiate a forward agreement with the padded seat vendor. Consider your options if forward contracts can impact your ability to purchase cheaper products in the future.
If you sell your employer's products, you can negotiate forward contracts to secure a buyer in advance. You may also use these agreements if you require help organizing immediate delivery. Consider your options if forward contracts can impact the flexibility of selling to other buyers. It's also essential you understand the current market conditions of the product you want to sell. Doing this can help you customize the contract accordingly.
FAQs about forward contracts
Here are common questions and helpful answers to help you gain more insights about forward contracts:
Can you cancel a forward contract?
You can cancel forward contracts after reaching a mutual agreement with the other party. This situation typically occurs before the contract ends or matures. For example, if you negotiate a contract to purchase groceries at the month's end, you may cancel your agreement within the month. Cancelling forward contracts typically requires paying a fee outlined in the contract specifications.
Are forward contracts legally binding?
Forward contracts are legally binding agreements. This implies that either party may consider legal actions if necessary. It's essential you evaluate the transacting product and anticipate situations that can impact its delivery. For example, suppose you negotiate a contract to sell cattle at the month's end. You can plan for severe drought conditions that can make moving cattle challenging or health conditions.
What is forward price?
Forward price, or forward rate, is the predetermined amount a buyer pays for a commodity, currency, or financial asset at a future date. It typically considers the current price you can sell or buy an asset for immediate delivery and the delivery date. Finding an asset's forward price often involves decimals, fractions, and exponents, so using a calculator is essential.
What is the difference between forward contracts and call options?
You can differentiate these agreements by determining whether transactions are obligatory. A call option gives a buyer the right to buy an asset at a set price in the future. Forward contracts refer to an obligation to purchase or sell an asset. You can use call options for securities. For example, many investors purchase call options for stocks and bonds.
How can you settle forward contracts?
Settling forward contracts can occur on a cash or delivery basis. A contract on a delivery basis typically requires a seller to supply the asset to the buyer, who makes cash payments on the settlement date. Alternatively, a contract on a cash basis only requires payments between a buyer and seller on the settlement date. For example, suppose you negotiate forward contracts involving two currencies. You can expect to make payments instead of exchanging a currency's banknotes.
Examples of forward contracts
You can review this example to understand forward contracts and learn more about negotiating them:
Example for sellers
This example shows how cattle sellers may negotiate forward contracts, which is popular in the country's cattle industry:
Arya and Paul are cattle farmers that want to sell 100,000 cattle in six months. They also want to secure the current price, so they negotiate a forward contract with their bank to sell 100,000 cattle for $10 million. At the end of the sixth month, cattle sell for $90 each in the market. This means that Arya and Paul's cattle are now worth $9 million. Despite the new price, the bank previously agreed to pay $10 million.
Arya and Paul meet with the bank's representatives to discuss the next contract steps. These representatives decide to settle the contract by paying $1 million. This is the difference between the initial contract price of $10 million and the current market price of $9 million. After completing their transaction at the bank, Arya and Paul sell their cattle for $9 million in the open market.
Example for buyers
This example outlines how corn buyers may negotiate forward contracts:
Jamal and Rebecca work at a company that processes corn, and an agricultural producer with two million bushels of corn meets them to negotiate a contract. This producer wants to sell their commodity in six months because they have concerns about a potential reduction in corn prices. After considering the forward price of $4.30 per bushel, Jamal and Rebecca agree to the producer's proposal.
In six months, corn sells for $5 per bushel, which is higher than the contract price. Because the price increases, the agricultural producer owes Jamal and Rebecca's employers $1.4 million. This is the difference between the total cost of two million bushels at $5 per bushel and the contract price of $4.30 per bushel. If the price of corn remains the same after six months, neither party pays, and the contract ends.
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