Before knowing the types of Forward Contract; we must understand what forward contract actually is.
A forward contract is a formal agreement between two parties, either individuals or businesses. The two parties to the contract agree to complete a specified transaction at a set price on a set date.
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 exchange and clearinghouse opens them up to additional risk.
A forward contract is a customizable derivative contract between two parties to buy or sell an asset at a specified price on a future date.
Forward contracts can be tailored to a specific commodity, amount, and delivery date.
Forward contracts do not trade on a centralized exchange and are considered over-the-counter (OTC) instruments.
For example, forward contracts can help producers and users of agricultural products hedge against a change in the price of an underlying asset or commodity.
Financial institutions that initiate forward contracts are exposed to a greater degree of settlement and default risk compared to contracts that are marked-to-market regularly.
How do Forward Contracts Work?
Forward contracts have four main components to consider. 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 in the payment that will be rendered in.
Forwards are not traded on centralized exchanges. Instead, they are customized, over-the-counter contracts that are created between two parties.
On the expiration date, the contract must be settled. One party will deliver the underlying asset, while the other party will pay the agreed-upon price and take possession of the asset.
Forwards can also be cash-settled at the date of expiration rather than delivering the physical underlying asset.
What are Forward Contracts Used For?
Forward contracts are mainly used to hedge against potential losses. They enable the participants to lock in a price in the future.
This guaranteed price can be very important, especially in industries that commonly experience significant volatility in prices.
For example, in the oil industry, entering into a forward contract to sell a specific number of barrels of oil can be used to protect against potential downward swings in oil prices.
Forwards are also commonly used to hedge against changes in currency exchange rates when making large international purchases.
Forward contracts can also be used purely for speculative purposes.
This is less common than using futures since forwards are created by two parties and are not available for trading on centralized exchanges.
If a speculator believes that the future spot price of an asset will be higher than the forward price today, they may enter into a long forward position.
If the future spot price is greater than the agreed-upon contract price, they will profit.
Types of Forward Contracts
There are a few different types of forward contracts for investors to be aware of.
Closed Outright Forward
This is the simplest type of a forward contract, where both parties agree to exchange currencies at a future date by locking in an exchange price.
These are also known as European contracts or Standard Forward Contracts.
These have the same functionality as any forward contract, except that the settlement period often extends over more than a year.
Generally, most forward contracts are short term contracts, which is what differentiates the long date forward contracts from the rest of them.
Usually, parties enter into forward contracts over a physical exchange of a commodity, an asset, or currency.
However, with non-deliverable forwards, the parties only exchange the difference between the contract rate and the spot rate at the time of maturity.
Such type of forward contract gives investors flexibility in exchanging the funds. Or, we can say that investors using such a contract have an option to exchange the funds before the settlement date.
Using this contact, parties can either exchange the funds outright or choose to make several payments prior to the settlement date.
Assume that Mr. X imports goods in India worth $500,000 from a US-based exporter. Being aware of exchange rate fluctuation, he enters into a flexible forward contract.
This will help him to make payments at different points of time during the period of the contract, whenever the exchange rates are favorable to him.
Closed Outright Forward
This is the simplest type of forward contract. We can also call such forward contracts European contracts or Standard Forward Contracts.
Such types of contracts allow investors to exchange the underlying asset at a specific future date.
Say, for example, you have entered into a trade with a foreign exporter. And, the date of payment is the 24th of next month.
You can lock in the exchange rate by entering into a closed outright forward contract for the 24th of next month.
Fixed Date Forward Contracts
In this type of forward contract, the parties exchange the underlying asset only at specific maturity date. Or, we can say, such contracts have a fixed maturity date.
Most forward contracts are fixed-date forward contracts only.
Option Forward Contract
These types of forward contracts are similar to flexible forward contracts. An option forward contract allows parties to exchange the underlying security on any date during a specific period.
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
- Lets companies hedge against changing commodity prices
- Flexible and customizable
- Riskier than futures contracts
- Can be highly complicated