When two parties make an agreement to buy or sell a product at a specific price, but the actual transaction takes place at some other date in the future, that's the essence of a forward contract. A spot contract is when a product is bought or sold immediately at its current price, while forward contracts are priced at a premium or discount to the spot rate. Forward contracts let investors lock in the price of an asset on the day the agreement's made. This becomes the price at which the product is transacted at the future date. This contracted price holds, regardless of whether the real price increases or decreases.
Businesses often use forward contracts when they're transacting overseas and wish to lock in a favorable exchange rate.
Protection Against Exchange Rate Fluctuations
Forward contracts, a type of derivative instrument, can be used as effective hedges in industries such as agriculture. Farmers use them to protect against the risk of crop prices dropping before they can harvest their crop. For example, a farmer plants a crop of wheat and expects the crop to yield 10,000 bushels at harvest time.
To protect himself against the risk of heat prices dropping, he will sell the entire 10,000 bushels that he expects to harvest to a buyer, before the actual harvest. The two parties make an agreement and fix the price of a bushel of wheat, with delivery to be made five months from the date of the transaction agreement. Money does not change hands at this time. The farmer has protected himself from possible currency exchange rate fluctuations and declines in the wheat market. Of course, he also takes the risk that the price of wheat will go up and he'll miss out on a higher price for his crop.
Hedging against Risk
For many people, risk management is the primary motivation for forward contracts. Company treasurers use forward contracts to hedge their risk related to foreign currency exchange. For example, a company based in the U.S. incurs costs in dollars for labor and manufacturing. It sells to European clients who pay in euros, and the company has a lead time of six months to supply the goods. In this case, the company is at risk from the uncertain market fluctuation of exchange rates. The company uses a forward contract to lock in a sale price for the product in six months, at today’s exchange rate.
The Possibility of Default
Forward contracts exist as a private agreement between two parties, with no standardization. They don't get traded on exchanges, and due to the customized nature of each contract, third parties don't have an interest in buying them, so they can't be resold. A forward contract has no immediate obligation, but as time moves forward the price for delivery, set on the original date of the contract, may change.
A forward contract can increase in value for one party and become a liability for another if the market value of the underlying assets changes. Forward contracts are a zero-sum game where, if one person makes $500, the other person loses $500.
Because no money changes hands at the time the contract's written, and because no "clearinghouse" acts as a middleman to protect both parties to the contract, the risk of default is potentially high. The seller may not deliver the product at the agreed-upon price or the buyer may not pay the agreed price. Forward contracts often include a price premium to compensate for this risk.
Product Quality Variations
Forward contracts often cover assets such as grain, beef, oil, precious metals, foreign currencies and certain financial instruments. Forward contracts often involve buying a product, sight unseen. A big problem with forward contracts for certain goods exists if the physical characteristics of the product vary from the original promise. For example, a forward contract for wool cannot guarantee the quality of the wool at the time of delivery. Wool might be stronger one year than the next because of wool quality variances from season to season. Quality variations in the product alter its market price, but with a forward contract, the seller has to pay the price as long as the contract states quality reaches a minimum agreed-upon level.