Forward contract definition

What is a forward contract?

A forward contract is an agreement between two parties to buy or sell an asset at a specified price on a predefined expiry date. Both parties have an obligation to fulfil their end of the agreement.

A forward contract can vary between different trades, making it a non-standardised entity. This means that it can be customised according to the asset being traded, expiry date and amount being traded.

Forward contracts are most commonly used for trading commodity markets, but they are also a popular tool for trading forex.

Forward contracts vs futures contracts

A forward contract is not to be confused with a futures contract. Both agreements give traders the obligation to buy and sell an asset (or settle the exchange in cash) at a set price in the future, However, there are a few key differences between them, these include:

Forward contracts are... Futures contracts are...
Traded over-the-counter (OTC) Traded on exchange
Non-standardised (can be customised) Standardised (can't be customised)
Negotiable Non-negotiable

However, trading futures and forwards with IG is slightly different because you aren’t trading directly on an exchange. So, when you trade index futures using CFD, what you are actually buying is a forward contract. For example, a futures position on IG’s FTSE 100 market is actually a forward contract for the equivalent of a FTSE 100 future.

Example of a forward contract

Let’s say you want to sell 100 tonnes of corn to a US mass retailer in 60 days at $150 per tonne. After the 60 days have passed, you would need to provide 100 tonnes of corn, and the retailer would be obliged to pay $15,000 (100 tonnes x $150) in return.

You would be obliged to sell at the agreed price, whether the value of corn is trading at $150 or not. This means that you might end up selling at a higher – or lower – than the market price when you take delivery.

If you or the buyer did not want to exchange the corn at the expiry date, you could choose to settle in cash. In this instance, no physical product is delivered. The settlement amount will be the difference between the agreed price and the current price – the buyer will pay the seller if the asset price drops, and the seller will pay the buyer if the asset price rises.

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.

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