Forwards are traded over-the-counter rather than on an exchange. This means they are flexible. The two parties involved can customize things like their expiration dates or the amounts of the commodities involved in the transactions. However, the lack of an exchange and clearinghouse opens them up to additional risk. An example of a forward contract would be two companies agreeing to a forward contract on June 1 that states that company A will sell 1,000 tons of grain to company B on Aug. 1 for $200 per ton.
How Forward Contracts Work
Forward contracts exist mostly to give large businesses a way to hedge against changing market values for commodities and currencies. Imagine a company that refines oil into gasoline and other products. The success of the company will depend largely on the price of oil. If oil is cheap, the company can make its products at a lower cost and secure higher profits. If the oil price rises, the company will need to accept less profit or raise its prices. Because commodity prices can be volatile, it can be hard for a business to predict future prices and make long-term production decisions. Forward contracts let these businesses lock in their raw-material prices ahead of time. For example, if oil is trading at $50 a barrel, the company might sign a forward contract with its supplier to buy 10,000 barrels of oil at $55 each every month for the next year. If the price of oil rises above $55, the company still only has to pay $55 for each barrel of oil, thanks to the contract. For example, if oil rises to $60 per barrel, the company will save $5,000 each month the price sticks at $60 per barrel. If the price of oil holds steady or drops, the company will lose money because it could have purchased oil for less on the open market. However, the business still has the benefit of knowing exactly what it will pay for the oil it needs far in advance. This makes financial planning much easier.
Types of Forward Contracts
There are a few different types of forward contracts for investors to be aware of.
Closed outright: This is the standard type of forward. Two parties agree to complete a transaction at a set price on a specific date.Flexible: With a flexible forward, the two parties can settle the contract prior to the date set in the contract. The settlement can happen in one transaction or over several payments.Long-dated: Most forwards mature in a short amount of time, such as three months. Long-date forwards can last much longer, sometimes a year or more.Non-deliverable: These forwards don’t involve the physical exchange of funds. Instead, the two parties simply exchange cash to settle the contract, with the amount paid depending on the contracted price and the market price of the underlying commodity or currency.
Alternatives to Forward Contracts
The most basic alternative to the forward contract is the futures contract. Like a forward, a futures contract lets two parties agree to conduct a transaction at a set price on a set date. Much like a forward contract, it can be useful for hedging against changes in commodity values. The primary difference is that futures are regulated, traded on a public exchange, and standardized by the clearinghouse involved in the transaction. The clearinghouse also plays a role in guaranteeing the performance of the transaction, which reduces the risk that one of the two parties involved will default. This makes futures safer, but less customizable and flexible than forwards.
Pros and Cons of Forward Contracts
Pros Explained
Lets companies hedge against changing commodity prices: Companies that rely on commodities as raw materials can better plan for the future by locking in prices ahead of time.Flexible and customizable: Unlike futures, forward contracts can be customized when it comes to things such as the settlement dates or the amounts of commodities exchanged.
Cons Explained
Riskier than futures contracts: Because forwards are traded over-the-counter, there’s more risk that one party won’t complete the transaction, and the contract can be harder to sell before the settlement date.Can be highly complicated: Forwards are derivatives that have a lot of moving parts, so they can be complicated and difficult to understand for beginners.
What It Means for Individual Investors
In truth, most individual investors won’t have a need to get involved with trading forward contracts. If you’re interested in the idea of trading derivatives or commodities, futures are a more standardized and easier-to-trade alternative to forwards.
