Pros and cons of a forward contract
Pros of a forward contract
Forward contracts are relatively easy to understand, which makes them a great tool for beginners. Forwards tend to be used as a means of speculation or hedging, as the contract price holds whether there is a price change to the asset or not – this means traders can be certain of the price they will be buying or selling at.
As mentioned, forward contracts offer great flexibility, as dates and amounts can be customised. Even though forward contracts have an agreed expiry on them, it does not mean that they have to be kept open for the entire duration. Most forward contracts can be closed early if you want to limit losses or take profits.
Cons of a forward contract
It is important to be aware of the risks both parties are exposed to when they take out a forward contract. First, there is no guarantee of product quality – as forwards are traded OTC rather than on exchange, there is no regulation over asset variation. However, if traders choose to settle in cash (instead of taking delivery of the asset) this would have no impact on the exchange.
And second, there is the risk of default. As a forward contract changes in price, its value increases for one party and becomes a liability for the other. This means there is a degree of counter-party risk, where the contract might not be honoured, despite obligation.