Forward Contract

What are Forwards?

A Forward is a general term that describes a financial contract (such as a derivative) where one party buys and another one sells a fixed quantity of a specific asset at a price fixed today for delivery and payment at a future date. The party to the contract that agrees to buy is called the ‘long’ side of the contract while the seller is  ‘short’. Forwards can be customized to suit the two parties, whereas a future is a standardized forward contract.

Basic Pricing of Forwards

Forwards are derivative instruments which can be customized to suit the traders’ needs. When the trade is agreed upon, this derivative, unlike an option, has no value to either the long or the short. However, if the underlier is moving up, the long side will benefit and the short will lose and vice versa.

Because there is no value in the contract at the time of trade there can be no gain or loss made by either party just by entering the trade. Therefore, the agreed price must be such that the above conditions are fulfilled. This is known as an arbitrage-free price. To see what this arbitrage-free price might be, let us consider the following equity forward:

Example of Forward Pricing

A trader has sold a stock forward (i.e. is short), for delivery in one year. The trader borrows US$100 to buy a share for US$100 and holds it until delivery. Interest on the borrowed money is US$5 (5%) and the stock pays a dividend in one year of US$2 (for simplicity let us assume the dividend is paid just before expiry of the contract).

In one year, the investor will collect the agreed forward price from the long, pay the interest (US$5 outflow) and loan (US$100 outflow) and receive the dividend (US$2 inflow). The net of these transactions is an outflow of US$103. This means that the minimum agreed forward price at the time of trade must be US$103. Otherwise, there would be an immediate gain or loss to the seller.

This describes the general idea of an arbitrage free price for forwards and futures. It can also be described with the following formula:

Fair forward/futures price = Spot price (US$100)

– Dividends (US$2)

+ Interest Cost (US$5)

= US$103

At delivery, the stock price might well have changed, which creates a gain for the long if the stock is up and a gain for the short if the stock is down. In other words, the long will benefit price increases from when the trade was agreed. However, unlike a cash buyer, the forward long does not benefit from dividend payments before delivery on the contrary, dividend payments bring the value of the share down. In other words, the long gets the price return on the stock, not the total return.

Described differently, buying a stock under a forward agreement is like borrowing money to get exposed to the price appreciation of the stock. Buying a future is therefore a way to create leverage on an investment.

The pricing example above is over-simplified. In reality, the timing of a dividend payment will need factoring in, the size of the dividend might be unknown or uncertain and the funding costs (interest) might differ between market participants.

Download the Excel Forward template. Simply enter the information and calculate forward prices for your chosen assets.

How Forward Contracts work

Forward contracts are essentially customized agreements between two parties to buy and sell an asset at a predetermined price on a specific future date. Forwards can be used for a range of assets such as stocks, currencies or commodities. If a breakfast cereal-producing company was concerned about the rising price of grain in its raw materials costs, then it may enter into a forward contract. This would effectively hedge the cost of the wheat or oats trading price over the desired time period.

The party agreeing to buy the asset takes a long forward position, while the party agreeing to sell takes a short forward position. The agreed-upon price at the inception of the contract is called the forward price. Settlement occurs on a future date, distinct from the spot date, which is the current settlement date.

What are Forward Contracts used for?

Forward contracts are often used for hedging purposes or for speculation in various financial markets. They are widely used in the FX market for companies or individuals to lock in exchange rates for future transactions. Additionally, they are used in commodities, interest rates, and other assets where parties wish to secure future prices to avoid market volatility. Forwards can also be used speculatively if traders have a view on market directions.

Forward Contracts vs. Futures Contracts

While both forwards and futures are agreements to transact at a specified price in the future, they differ in several ways. Forwards are typically private, customizable contracts traded over-the-counter (OTC) and are not standardized. Futures, on the other hand, are standardized contracts traded on exchanges. This makes futures more liquid and subject to daily settlement, reducing counterparty risk. Forwards, lacking this daily settlement, are more exposed to credit risk.

The most traded futures contracts include the S&P 500 futures, euro-dollar futures and also crude oil futures.

Forwards Contracts

• Forwards contracts are customized agreements between two parties to buy or sell an asset at a specified future date for a price agreed upon today
• Forwards are not traded on exchanges and are typically used by sophisticated investors
• These contracts do not have a standard template, making them complex and often kept out of the public eye

Futures Contracts

• Futures contracts, on the other hand, are standardized agreements traded on exchanges
• The uniformity of futures contracts fuels liquidity, allowing for quick entry and exit from positions as market conditions evolve
• Futures contracts have a wealth of data available for valuation, and their market price is readily accessible

Example of a Forward Contract

An example of a forward contract would be a trader who enters into a contract to buy 10 million U.S. dollars in exchange for euros, at a rate of 1.2030, with settlement to occur in three months. This agreement fixes the exchange rate in advance, allowing the trader to manage foreign exchange exposure, regardless of future rate fluctuations.

On the transaction date, the parties determine and agree upon the specifics: the size of the trade, the forward date on which the forward contract will settle, and, crucially, the forward price.

When the forward date arrives, settlement occurs: our trader will receive the 10 million US dollars and pay out 8.31 million euros (10m divided by 1.2030). Should the US dollar appreciate over the course of these three months, and assuming this transaction was a speculative bet on a strengthening dollar, the trade could yield substantial profits.

Forward Contract payoff diagram and example

In a payoff scenario, if the price of the underlying asset (such as stock) increases above the forward price by the time of settlement, the buyer gains since they purchase below the market value. Conversely, if the asset’s price falls below the forward price, the buyer incurs a loss. For example, if a forward contract fixes a price of US$75 for Microsoft stock, and at settlement, the stock is worth US$85, the buyer gains US$10 per share. However, if the stock falls to US$60, the buyer must still pay US$75, resulting in a US$15 loss per share.

Risks of Forward Contracts

Forward contracts carry several risks, primarily counterparty risk, as they are private agreements without an intermediary or exchange backing them. If one party defaults, the other may incur losses.

Additionally, forwards lack the liquidity of exchange-traded contracts, making them harder to exit. Market price fluctuations can also lead to significant gains or losses, depending on the direction of the asset’s price relative to the agreed forward price.

Conclusion

Forward contracts are typically used by sophisticated investors to create customized buy or sell contracts to be settled at a date in the future. They are most useful for hedging as they can be created to suit a particular purpose such as hedging raw material costs (soft commodities or oil) or currency risk. As they are customized, they can be used for a wide range of assets including indices and stocks. Forwards typically trade OTC and are private. A future is a standardized version of a forward contract – these trade on exchanges and are marked-to-market so any differences are settled daily.