by In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the same as the value date where the securities themselves are exchanged. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.
The following are the four components:
- Asset: This is the underlying asset that is specified in the contract.
- Expiration Date: The contract will need an end date when the agreement is settled and the asset is delivered and the deliverer is paid.
- Quantity: This is the size of the contract, and will give the specific amount in units of the asset being bought and sold.
- Price: The price that will be paid on the maturation/expiration date must also be specified. This will also include the currency that payment will be rendered in.
Features
No premium: Since these contracts are not traded in markets, so a premium is involved.
Not traded: Forward contracts are designed to meet specific requirements of company. These contracts are not traded in the market.
No margin: Small fees are required to enter into a forward contract.
Physical delivery: These are inflexible and bind in nature. Therefore, at the time of delivery, physical delivery is required.
Expensive: More expensive than other hedge options because, these contracts are tailored made.
Terminologies
- Quantity: This mainly refers to the size of the contract, in units of the asset that is being bought and sold.
- Underlying Asset: This is the underlying asset that is mentioned in the contract. This underlying asset can be commodity, currency, stock, and so on.
- Price: This is the price that will be paid on the expiration date must also be specified.
- Expiration Date: This is the date when the agreement is settled and the asset is delivered and paid.
Working:
Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Alice currently owns a $100,000 house that she wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year’s time of $104,000 (more below on why the sale price should be this amount). Alice and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Alice will have the short forward contract.
At the end of one year, suppose that the current market valuation of Alice’s house is $110,000. Then, because Alice is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one needs only to recognize that Bob can buy from Alice for $104,000 and immediately sell to the market for $110,000. Bob has made the difference in profit. In contrast, Alice has made a potential loss of $6,000, and an actual profit of $4,000.
The similar situation works among currency forwards, in which one party opens a forward contract to buy or sell a currency (e.g. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.
In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say US$75.2 million at the current rate these two amounts are called the notional amount(s). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.
