There’s no doubt that finance can get complicated from time to time. With copious amounts of industry jargon and a vast array of complex products, it’s no wonder people lack the financial literacy required to navigate the markets successfully.
One of the more frequently misunderstood financial instruments is forward contracts, which make up an important part of the derivatives world. These non-standardized contracts facilitate corporate FX hedging and, as a result, play a pivotal role in helping companies and individual investors manage market volatility. On that note, here is a brief guide on everything you need to know about these intricate yet profoundly important financial tools.
What are forward contracts?
A forward contract is a contractual agreement between two parties that outlines the intention to conduct a transaction (the buying and selling) of an underlying asset at a predetermined price on a set date in the future. Forward contracts are typically used in the commodity or FX (foreign exchange) market to enable companies to hedge against future price changes.
Essentially, this means that the buyer is entering into a long position, whereas the seller is entering into a short position.
For example, let’s say you are an apple farmer that wants to sell your produce at the current market rate of $1.00 per apple, but you expect that the prices will fall within the next few months. In this instance, you could enter a forward contract with a buyer to sell them 50 apples at a rate of $1.00 per apple on a predetermined date in the future. If the market rate falls below $1.00 per apple during that time, then you are protected. However, if the price rises, then you will have missed out on the potential to make even more profit.
In FX markets, currency forward contracts can be used to exploit arbitrage opportunities at the cost of carrying different currencies. Buying a forward contract is also a common practice when hedging or speculating in the market, as they protect traders from volatility.
How forward contracts work
Forward contracts are traded OTC (over-the-counter), which means that they are not offered on exchanges. Instead, these contracts are bought and sold peer-to-peer, which opens up a plethora of opportunities for the involved parties to customize the terms of the agreement.
For example, the two parties can establish customized expiration dates and quantities for each transaction. Although, it is worth pointing out that this exposes each party to a significant amount of risk since each transaction is not regulated by an exchange (more on this later).
Different types of forward contracts
The vast majority of forward contracts are specific to currency transactions, although there are plenty of other examples of when forward contracts are used in the business world. Let’s take a look at some of the most common types of forward contracts:
- Window forwards – These contracts give a window where transactions may be completed, such as between the 15th to the 19th of a particular month. This gives more flexibility to the buyer to choose a favorable price for their purchase.
- Long-dated forwards – Standard forward contacts have an expiry date of 12 months, whereas long-dated forwards can have maturity dates of up to 10 years.
- Flexible forward (option forward contract) – Flexible forwards give investors more flexibility when deciding when to exchange their funds, thus allowing them to make payments at multiple points throughout the period of the contract.
- Fixed date forward contract – The most common type of forward contract. Fixed date agreements are settled on one particular maturity date, with no room for flexibility.
- Non-deliverable forward (PDF) – NDFs do not involve the physical delivery of the underlying assets. Instead, the two parties simply exchange the difference between the two assets on the date of settlement. The difference being the price taken on the contract data and the settlement date. NDFs are typically used by those that do not want to commit funds to forward contracts but still want to protect against volatility.
Risks involved with forwarding contracts
As mentioned, there are risks involved when trading a forward contract for businesses. For starters, there are regulatory concerns that parties need to be aware of. Since these assets are traded OTC, there is no regulatory body that oversees the transaction unless, of course, there are clear breaches of the law. Therefore, the contract is executed based on the mutual consent of both parties, which dramatically increases the potential for defaults.
Secondly, forward contracts suffer from low liquidity, which means that investors may not be able to execute their strategies as planned due to volume-imposed limitations. This can make forward contracts risky propositions, especially if large sums are involved.
Lastly, forward contracts can be difficult to establish since it may be challenging to find a suitable counterparty. Furthermore, each contract requires both parties to tie up capital, and there are no intermediate cash flows permitted before settlement.
In summary
Forward contracts are a key instrument that inventors and businesses use to mitigate market volatility by hedging against a variety of underlying assets. However, while these contracts are very common, particularly in the FX market, it can be difficult to find a counterparty prepared to agree to the conditions and lock up money for such a lengthy period of time, especially since the instruments are traded over the counter, making them unregulated.
As a result, most investors prefer futures contracts as a safer option since they are openly traded on public exchanges and are standardized. This means that regulators guarantee the transaction’s performance, reducing the risk that one of the two parties involved may default.
