Understanding Forward Contracts: Benefits, Risks, and How They Work

If you’re a business owner, investor, or someone who deals with financial instruments, you may have heard of forward contracts. A forward contract is a financial agreement between two parties to buy or sell an asset at a predetermined price and date in the future. The asset can be anything, including currencies, commodities, or securities. When it comes to managing risks associated with future market fluctuations, a forward contract can be an essential tool for businesses and investors. The contract is a customized agreement between the buyer and seller that includes specific details, such as the quantity, price, and date of delivery. Unlike a futures contract, which is standardized and traded on exchanges, a forward contract is a private agreement negotiated directly between the parties involved.

In this blog, we will take a closer look at forward contracts, how they work, and their advantages and disadvantages.

How Forward Contracts Work

A forward contract is a legal agreement between two parties — a buyer and a seller — to buy or sell an asset at a future date. The price of the asset is agreed upon when the contract is made, and the transaction takes place at the date of delivery. The asset can be anything from commodities like oil, gold, and wheat to financial instruments like currencies and stocks.

Forward contracts are customized and are typically used by businesses to hedge against price fluctuations or to lock in a price for a future purchase or sale.

Below are few examples to understand the forward contract better,

Example #1 : A farmer may use a forward contract to sell their crops at a predetermined price to protect themselves against falling prices. On the other hand, a manufacturer may use a forward contract to purchase raw materials at a set price to protect themselves against rising costs.

Example #2: A manufacturer who needs a particular raw material can enter into a forward contract with a supplier to buy the material at a fixed price. This helps the manufacturer to manage their costs and avoid the risk of price increases in the future.

Example #3: Suppose that John, a coffee shop owner, wants to purchase 1,000 pounds of coffee beans from a local farmer, Jane, in six months. However, he’s concerned that the price of coffee beans may rise during this time. To mitigate this risk, John and Jane enter into a forward contract. They agree that John will purchase 1,000 pounds of coffee beans from Jane in six months at a price of $2 per pound.

In six months, if the market price of coffee beans is $3 per pound, John has secured a price of $2 per pound, effectively saving him $1 per pound. Conversely, if the market price of coffee beans is $1.50 per pound, John is obligated to buy the coffee beans at $2 per pound, effectively paying a premium of $0.50 per pound.

Advantages of Forward Contracts

Price Certainty: Forward contracts provide price certainty for the buyer and seller, allowing them to lock in a price for an asset in advance. This helps both parties to manage their risks and plan for the future.

Customization: The terms of a forward contract can be customized to meet the specific needs of the parties involved. The contract can specify the quantity, quality, and delivery date of the underlying asset, providing flexibility to the parties.

Reduced Transaction Costs: Forward contracts are private agreements between two parties, eliminating the need for a middleman or exchange to facilitate the transaction. This can result in reduced transaction costs for the parties involved.

Disadvantages of Forward Contracts

Counterparty Risk: A forward contract is an agreement between two parties, and there’s always a risk that one party may default on their obligation. This could result in financial loss for the other party.

Market Risk: The value of the underlying asset can fluctuate between the time the contract is made and the delivery date. This could result in one party benefiting at the expense of the other party.

Liquidity Risk: Forward contracts are not traded on an exchange and are often illiquid. This could make it difficult for parties to exit their position or find a counterparty to take the other side of the trade.

Payment Defaults : If one party defaults on the contract, the other party may be left with a significant financial loss. In addition, because the contract is a private agreement, there is no guarantee that the other party will fulfill their obligations.

Conclusion

Forward contracts are a useful tool for managing risks and hedging against price fluctuations. They allow buyers and sellers to lock in a price for a future transaction, which can be beneficial for businesses that require specific delivery dates or have unique requirements. However, forward contracts also come with some disadvantages, including counterparty risk and lack of standardization. It is essential to consider these factors when deciding whether to use a forward contract or another financial instrument.