Forward contract

Definition

A forward contract is a financial agreement between two parties to buy or sell a specific asset, such as commodities, currencies, or financial instruments, at a predetermined price on a future date.

What is a forward contract?

A forward contract is a type of derivative contract where the terms, including the price and delivery date, are established at the outset of the agreement. Forward contracts are commonly used to hedge against price fluctuations or to speculate on future price movements.

The key features of a forward contract are:

1. Customisation: Forward contracts are customisable to meet the specific needs of the parties involved. They can be tailored in terms of the asset being traded, the contract sise, the delivery date, and the agreed-upon price.

2. Private agreement: Forward contracts are private agreements negotiated directly between the parties. They are not traded on exchanges, which means the terms are not standardised and can vary between contracts.

3. Obligation to fulfill: Both parties are legally obligated to fulfil the terms of the contract at the agreed-upon future date. This means the buyer must buy and the seller must sell the asset at the specified price, regardless of market conditions at that time.

Regarding regulation, the level of regulation for forward contracts can vary depending on the jurisdiction, the type of asset involved, and the parties engaged in the transaction. In some cases, forward contracts may not be as heavily regulated as other financial derivatives like futures contracts. However, regulations surrounding derivatives have evolved over time, particularly in response to financial crises and the need for transparency and risk mitigation.

In many countries, financial authorities have implemented regulations to ensure fair practices, mitigate risks, and promote market stability. For instance, derivatives markets may be subject to oversight by financial regulatory agencies. Additionally, depending on the nature of the underlying asset, specific regulations may apply to certain types of forward contracts.

It’s important to note that while forward contracts offer flexibility and customisation, they also carry risks, such as counterparty risk (the risk that the other party may not fulfil its obligations) and price risk (the risk that the market price at the contract’s maturity is unfavourable). Traders and businesses should carefully consider these risks and the regulatory framework in their jurisdiction before engaging in forward contract transactions.

Example of forward contract

Company ABC, based in the US, is expecting to receive €1,000,000 from a European client in three months. To hedge against the risk of currency exchange rate fluctuations, ABC enters into a forward contract with a financial institution.

• Current exchange rate: 1 USD = 0.85 EUR
• Forward contract agreement: ABC agrees to exchange €1,000,000 for $1,200,000 in three months.

At the end of three months, regardless of the prevailing exchange rate, ABC is obligated to exchange €1,000,000 for $1,200,000. If the exchange rate at that time is favourable (e.g., 1 USD = 0.80 EUR), ABC still exchanges €1,000,000 for $1,200,000, gaining a currency advantage.

Conversely, if the exchange rate becomes less favourable (e.g., 1 USD = 0.90 EUR), ABC still exchanges €1,000,000 for $1,200,000, but avoids the potential loss associated with the deteriorating exchange rate.

In this example, the forward contract helps Company ABC manage the risk associated with currency fluctuations, providing certainty about the amount of dollars they will receive in exchange for euros at a future date.