A forward contract is a tailor-made contract to meet specific needs of the investors that calls for the delivery of a specific quantity of a specific product at some time in the future at a predetermined price.
Forward contracts are traded in over-the-counter (OTC) market by institutions & investors and cover a wide range of commodities such as agriculture produce, livestock, energy, metals and financial products such as market indices, interest rates and currencies.
The primary purpose of the forwards market is to allow those who wish to manage price risk (the hedgers) to transfer that risk to those who are willing to take that risk (the speculators) in return for an opportunity to profit. Also since forwards are totally customisable contracts they can fit the investor needs easily. And because it’s not a standardised contract like future contract it can have almost anything as underlying as long as both parties of the trade agree.
Producers and manufacturers can make use of the forwards market to hedge the price risk of commodities that they need to purchase or sell in order to protect their profit margins. Businesses employ a long hedge to lock in the price of a raw material that they wish to purchase some time in the future. To lock in a selling price for a product to be sold in the future, a short hedge is used.
Speculators assume the price risk that hedgers try to avoid in return for a possibility of profits. They have no commercial interest in the underlying commodities and are motivated purely by the potential for profits. However due to the illiquidity in the forwards market investors trading forwards are generally hedgers rather than speculators.
In March, a speculator bullish on soybeans purchased one May Soybeans forward at $9.60 per bushel. Each Soybeans forward contract represents 5000 bushels.
Come May, the price of soybeans has gone up to $10 per bushel. Since the price has gone up by $0.40 per bushel, the speculator can buy soybeans at $9.60 and can sell it in the market for $10 with a profit of ($10 - $9.60) x 5000 bushels = $2000.
Types of Forwards
Forwards can assume anything as underlying. These include Equities, Commodities, FX, and Debt Instruments. Among these FX and Debt Instruments are more widely used.
Forwards are widely used in FX market due to simple nature of the market. Most of the time investors may need to convert their currency in another one not instantly but sometime in the future and they don’t want to take the risk of exchange rate moves.
A swap point is added on top of the current parity when trading forwards on FX. Swap point might either be negative or positive depending on the interest rate differences of the currency pair. Assume we want to buy currency A with annual interest rate of 5% and sell currency B with annual interest rate of 8% in the future. If we go for A the swap point will be positive (meaning we will pay more) because of the higher interest we get from currency B until the maturity.
Time to time investors may want to buy bonds or other debt instruments on a future date. In this case they can buy forwards on these bonds. The forward price of the bond will be affected by the yield of the bond and effective repo rate in the market. Assuming a bond trading at 100 with a yield of 8% maturing in one year where the repo rate is 5%, we can calculate the forward price as follows;
Instead of buying the bond if you deposit your $100 for a year you will have $105 at the end. If you buy the bond at 100 and keep it one year, you would end up $108 with the coupon payment. So keeping the bond looks more attractive in terms of return. Not to have any arbitrage opportunities, the forward price of the bond should be $100 - $3 = $97 ($8 - $5 = $3). By buying the forward at $97 and adding $8 coupon on top of it will be same as depositing your money. This means there’s a discount of bond yield - repo rate. Since bond yields are higher than repo rates in general, forward price of the bonds tends to be less than the market price.
The forward market for commodities is less liquid than the previous ones mentioned above due to the exchange traded futures. However due to the flexible nature of the forwards companies may prefer forwards to meet their specific needs like date of delivery, quantity, quality, delivery point, etc.
A cost of carry would be added on top of the spot price of the underlying commodity to calculate the forward price. This cost of carry will be the sum of depositary costs and interest return that couldn’t be invested due to sale on a future date.
The forward market for equities is not very liquid either. As the shares already trade in an exchange, generally future/forward type contacts are structured synthetically by buying a call option and selling a put option with same strikes. Please check call and put option definitions.
Forwards vs. Futures
Forwards and futures have the same pay-off and they have the same exposure to the underlying however the differences below make one of them more desirable depending on the investor’s choice.
Forward contracts are not regulated whereas future contracts are regulated by the government.
Forward contracts have high counterparty risk because it’s a contract between buyer and seller only. On the other hand future contracts have low counterparty risk due to its regulated nature.
Future contracts are standardized and an initial margin is required whereas forwards are customised to customer needs and usually no initial payment is needed.
Future contracts are standardized but forwards are customised to customer needs
For forwards deal is negotiated directly by the buyer and seller. However futures are quoted and traded on the Exchange.
There’s no guarantee for forwards. It is very difficult to undo the operation; profits and losses are cash settled at expiry. For Futures, both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.
There’s no institutional guarantee for forwards. The clearing house acts as a institutional guarantee for futures.
Method of Pre-termination
For forwards investor needs to take opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty. However futures are closed by taking opposite position in the exchange and there’s no counterparty risk.