What is a forward contract?

A forward contract is a tailored agreement between two parties to buy or sell an asset at a predetermined price on a specified future date. Unlike standardized contracts, forward contracts are highly customizable, allowing the parties to decide on various terms such as the asset type, quantity, and expiration date. This flexibility makes forward contracts a popular tool in both commodity markets and forex trading.

How does a forward contract work?

In a forward contract, both parties are obligated to fulfill their ends of the agreement. For example, if a seller agrees to sell 100 tonnes of corn to a buyer at $150 per tonne in 60 days, they must complete the transaction once the contract expires. The seller will provide the 100 tonnes of corn, and the buyer will pay $15,000. Regardless of the market price of corn at the time of delivery, the agreed-upon price remains fixed.

Additionally, forward contracts can be settled in cash instead of physical delivery. In this case, the settlement amount will be the difference between the agreed price and the current market price. If the asset’s price drops, the buyer compensates the seller, and if it rises, the seller compensates the buyer.

What is the difference between forward contracts and futures contracts?

While both forward and futures contracts obligate the parties to trade an asset at a set price in the future, they have some key differences:

• Trading Venue: Forward contracts are traded over-the-counter (OTC), whereas futures contracts are traded on exchanges.
• Standardization: Forward contracts are non-standardized and customizable, while futures contracts are standardized and cannot be customized.
• Negotiability: Forward contracts are negotiable, allowing the terms to be adjusted between the parties. In contrast, futures contracts are non-negotiable once the terms are set by the exchange.

Interestingly, when trading with certain platforms like IG, you might be trading forward contracts even when dealing with what appears to be futures contracts. For instance, an index future position on IG’s FTSE 100 market is actually a forward contract equivalent to a FTSE 100 future.

Can you provide an example of a forward contract?

Let’s consider a practical example. Suppose you agree to sell 100 tonnes of corn to a U.S. mass retailer at $150 per tonne, with the transaction set to occur in 60 days. Upon the contract’s expiration, you must deliver the 100 tonnes of corn, and the retailer will pay you $15,000. If the market price of corn rises to $160 per tonne during this period, you would still be obliged to sell at the agreed price of $150 per tonne, potentially resulting in a lower profit. Conversely, if the market price falls to $140 per tonne, you would benefit by selling at the higher agreed price.

If either party prefers not to exchange the physical corn, they can opt for cash settlement. In this scenario, no physical product is exchanged. Instead, the settlement amount is the difference between the agreed price and the current market price. If the market price drops, the buyer compensates the seller, and if it rises, the seller compensates the buyer.

What are the pros and cons of forward contracts?

Pros

Forward contracts offer several advantages, especially for beginners:

• Simplicity: Forward contracts are relatively easy to understand, making them an excellent tool for novice traders.
• Price Certainty: The contract price remains fixed, providing certainty for both buying and selling parties regardless of market fluctuations.
• Flexibility: Forward contracts are highly customizable in terms of asset type, quantity, and expiration date, offering great flexibility to traders.
• Early Closure: Most forward contracts can be closed before the expiration date, allowing traders to limit losses or take profits early.

Cons

However, forward contracts also come with certain risks:

• Product Quality Risk: Since forward contracts are traded OTC and not regulated by exchanges, there’s no guarantee of product quality. This risk can be mitigated if traders choose cash settlement instead of physical delivery.
• Counterparty Risk: The value of a forward contract can change, becoming an asset for one party and a liability for the other. This introduces counterparty risk, where the contract might not be honored despite the obligation.

In summary, forward contracts are powerful trading tools that offer significant flexibility and price certainty. However, they also come with inherent risks, including product quality and counterparty risk. Understanding these aspects can help traders make more informed decisions and effectively manage their trading strategies.