Forward Contracts

what are forward contracts?

A forward contract is an agreement between two parties to buy or sell an asset on a specified date in the future for a specified price.

Forward contracts can be for the purchase or sale of a commodity such as coffee beans or for the purchase or sale of foreign currency.

Companies enter into forward contracts when there is an uncertainty about a future price of something that they know that they will need to buy or sell in the future. Because of the uncertainty of the price, there is a risk that the price will move in the wrong direction before the future transaction takes place.

By entering into a forward contract, the parties are able to eliminate that risk of the price moving in the wrong direction.

A forward contract is entered into to hedge (protect) the parties from a future price change in the item. The party that will sell the asset has a risk that the price will fall in the future and the party that will purchase the asset has a risk that the price will rise. By entering into a contract now that guarantees the price for the transaction in the future, both parties manage their risk by protecting themselves from a change in the price of the asset.

At that time in the future when the transaction takes place, one party will have a gain because the forward contract price was more beneficial to them than the actual market price, and the other party will have an equal amount of a loss.

The two parties in the forward contract are sometimes referred to as the “long” party and “short” party. This term refers to whether a party to a forward contract is the buyer of the asset, or the seller of the asset.

• The long party is the party that has agreed to purchase the asset in the future at the forward contract price, regardless of the current market price on the expiration date of the contract. The buyer is protected against a possible increasing price of the asset.
• The short party is the party that has agreed to sell the asset in the future at the forward contract price, regardless of the current market price on the expiration date of the contract. The seller is protected against a possible decreasing price of the asset.

During the life of the forward contract, the value of the forward contract is the difference between the current market price of the underlying asset and the current present value of the forward (delivery) price.

The value of the forward contract will fluctuate during its lifetime because the current market price of the underlying asset will fluctuate.

The distinguishing characteristic of forward contracts is that they are not traded on exchanges. They are traded privately in the “over-the-counter” market. Brokers may be used to bring together the buyer and the seller, who then negotiate the terms of the contract, but two parties may simply negotiate forward contracts between themselves. Because they are not traded on exchanges, there is no secondary market for forward contracts.

On the expiration date, both parties are committed to completing the buy-sell transaction