Forward Contract – Overview, Example and Risks

A forward contract is a financial instrument used in trading and finance, involving an agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today.

Table of Contents

• About forward contracts
• Forward contract example
• Trading in forward contracts
• Methods of Settlement
• Deciding the forward price
• Future vs. forward contract
• Risks associated with forward contracts

What is Forward Contract?

A forward contract is an agreement between two parties to trade an asset on a set date in future. These are one of the oldest types of derivative instruments. These are over-the-counter instruments since they are not traded on a centralized exchange. Let us see a forward contract example to understand the concept. 

Forward contracts are financial instruments that have the following characteristics:

• They are binding forward trade agreements.
• You cannot trade them on a centralised exchange. 
• They can be customised at any time during the trading duration.
• These can be traded through CFDs and spread betting.
• Its value varies with the value of the underlying asset.
• You cannot exit these before the expiry date.

Example of Forward Contract

First, let us understand the concept with a very simple scenario:

1. Suppose there are two parties involved; John and Gabe. 
2. John owns a factory worth $200,000 and he wants to sell it. Gabe wants to buy a factory. 
3. John and Gabe enter into a forward contract. 
4. According to this contract, John will sell the factory to Gabe for $210,000 after six months on a specified date. 
5. The selling price has been decided according to certain conditions that we will discuss further. 
6. After six months, as per the actual calculation, the factory is worth $2,15,000. 
7. This means that John is losing out on $5,000. This is his potential loss. His actual profit is $10,000 ($210,000-$200,000). 
8. On the other hand, Gabe has made a profit of $5,000 because he can sell this factory for $215,000 that he bought for $210,000.

The reverse is also possible. Suppose, the factory’s worth goes down to $198,000. In this case, John will make a profit worth $12,000. Gabe will face a loss of $2,000 since he will be unable to recover the entire $200,000 if he tries to sell off the factory.

Forward Trading

Forward contracts are traded in the over-the-counter (OTC) market and not on any exchange. Let us consider another example of forward trading to understand the process.

• Suppose an agricultural supplier has 1000 barrels of white sugar that he wants to sell in six months. 
• The total current value of these barrels is £10,000. 
• The supplier is concerned about unfavourable weather conditions and agrees to sell these barrels to an international buyer at the spot market price of £10,000.

After six months, three of the following can happen to the spot price 

1. The spot price is more than the contract price: The supplier owes the difference between the current spot rate and contracted future price.
2. It is lower than the contract price: The buyer owes the difference between the contracted future price and the current spot rate.
3. Spot price remains the same: Contract is considered to be close without any party owning anything.

Methods of Settling Forward Contracts

After the expiry of a forward contract, the transaction is considered to be settled in two ways. 

1. Physical Delivery 

Under this settlement, when the transaction is finalized, party that is long the forward contract position will pay party that is short the position. This occurs when the asset is actually delivered.

2. Cash Settlement 

A cash settlement is more complex in comparison with a delivery settlement. Cash settlement helps in simplifying the delivery process. Let us understand this with the help of an example.

• Suppose a tea company agrees to buy 1000 tonnes of tea leaves at 5 lakh per tonne through a forward contract on 30th November of the same year.
• By November end, the tea is selling at 4 lakh per tonne in the open market.
• The tea company, which is long the forward contract position, will receive an asset that is currently worth 4 lakh per tonne. 
• Since the company agreed at 5 lakh per tonne, it may request the farmer to sell tea leaves at 4 lakh per tonne in the open market.
• The tea company will make the cash payment of 1 lakh per tonne to the farmer. According to this, the farmer will still receive 5 lakh per tonne.
• The company will purchase the necessary tonnes of tea from the open market at 4 lakh per tonne.
• The net effect will be the payment of each tonne to the farmer. 

Deciding Trading Prices in Forward Contracts

Forward price or forward rate is a predetermined and agreed upon a fair price. The fundamental method of determining forward price is considering two questions:

• What should be the selling price for the seller to maximize gains?
• What should be the acceptable cost price for the buyer to maximize gains? 

To calculate the forward price, a number of factors are taken into consideration. These may include interest, cost to sell an underlying asset, current spot rate, etc. 

F = S₀ x e^rT

F = The contract’s forward price

S₀ = Underlying asset’s current spot price

e = The mathematical irrational constant approximated by 2.7183

r = The risk-free rate applicable to the forward contract life

T = Delivery date (in years)

Future Contract vs. Forward Contract

You might confuse it with future contracts but there is a slight difference between the two. 

Risks Associated With Forward Contracts

• The forward market size is difficult to be estimated since the forward contract details are restricted to buyers and sellers. The general public lacks the knowledge.
• There is a lack of transparency associated with the use of forward contracts. Due to this, there are certain risks as well. 
• Trade completion can become complicated as there is no formalized clearinghouse.
• Huge losses may occur if derivatives contracts are not structured properly.
• Due to the non-standard nature of forward contracts, they can only be settled on the settlement date. Unlike futures, they are not marked to market.