What Is a Forward Contract?

A forward contract is an agreement between two parties to enter into a transaction at a specific rate and on a specific future date. They are often used in the commodity or forex market to allow companies to hedge against future price changes.

Learn the details of what futures contracts are and why it is important to understand them.

Definition and examples of futures contracts

A forward contract is a formal agreement between two parties, individuals or companies. The two parties to the contract agree to complete a specific transaction at a fixed price on a specified date.

Forward contracts are traded over the counter rather than on an exchange. That means they are flexible. Both parties involved can customize things like their expiration dates or the values ​​of the goods involved in the transactions. However, the lack of a stock exchange and clearing house exposes them to additional risks.

When you buy a forward contract over the counter, it is often difficult to sell it later. You will probably have to keep the contract until it expires.

An example of a forward contract would be two companies that enter into a forward contract on June 1 that states that Company A will sell 1,000 tons of grain to Company B on August 1 for $ 200 per ton.

How referral contracts work

Forward contracts exist primarily to provide large companies with a way to hedge against changes in the market values ​​of commodities and currencies.

Imagine a company that refines oil into gasoline and other products. The success of the company will largely depend on the price of oil. If the oil is cheap, the company can make its products at a lower cost and make higher profits. If the price of oil rises, the company will have to accept less profit or raise its prices.

Since commodity prices can be volatile, it can be difficult for a company to predict future prices and make long-term production decisions. Futures contracts allow these companies to set commodity prices in advance.

Forward contracts can involve the exchange of currency and other goods, not just commodities.

For example, if oil is trading at $ 50 a barrel, the company can sign a forward contract with its supplier to buy 10,000 barrels of oil at $ 55 each month for the next year.

If the price of oil rises above $ 55, the company will still have to pay just $ 55 per barrel of oil, thanks to the contract. For example, if oil rises to $ 60 a barrel, the company will save $ 5,000 a month and the price will be $ 60 a barrel.

If the price of oil remains stable or falls, the company will lose money because it could have bought oil for less on the open market. However, the company still has the advantage of knowing in advance exactly how much it will pay for the oil it needs. This makes financial planning a lot easier.

Types of future contracts

There are a few different types of forward contracts that investors should be aware of.

Fully Enclosed - This is the default attacker type. Two parties agree to complete a transaction at a fixed price on a specific date.

Flexible - With flexible routing, both parties can settle the contract before the date stipulated in the contract. Settlement can take place in one transaction or in multiple payments.

Long-term: Most resubmissions expire in a short period of time, such as three months. Long-term referrals can take much longer, sometimes a year or more.

Undeliverable - These references do not imply the physical exchange of funds. Instead, the two parties simply exchange money to settle the contract, and the amount paid depends on the contracted price and the market price of the underlying commodity or currency.

Contract forwarding alternatives

The most basic alternative to a forward contract is a futures contract.

Like a forward contract, a futures contract allows two parties to agree to enter into a transaction at a fixed price on a certain date. Like a forward contract, it can be useful to protect against changes in the value of commodities.

The main difference is that futures are regulated, traded on a public exchange, and standardized by the clearinghouse involved in the transaction. The clearinghouse also has the function of ensuring that the transaction is carried out, which reduces the risk of default by one of the parties involved.

This makes futures more secure, but less customizable and flexible than futures.

Pros and cons of futures contracts

Pros

It allows companies to protect themselves against changes in the prices of raw materials.

Flexible and customizable

Cons

Riskier than futures contracts

it can be very complicated

What does this mean for individual investors?

In fact, most individual investors will not need to engage in forward trading contracts. If you are interested in the idea of trading derivatives or commodities, futures are a more standardized and easier to trade alternative to forward contracts.

We hope you enjoy watching this video about the Forwarding contract introduction

Source: Khan Academy

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