Forwards
Forwards are financial contracts between two parties that agree to buy or sell an asset at a specified price (the forward price) on a future date (the delivery date). Unlike futures contracts, forwards are typically traded over-the-counter (OTC), meaning they are customized agreements negotiated directly between the buyer and seller, rather than standardized contracts traded on exchanges.
Features
- Forwards are structures whereby two parties confirm, in advance for both, to buy or sell an asset at a set price (the forward price) on some future date.
- They can be somehow tailored in that they can either be asset-based, quantity-based, price-based, or date-based.
- Nonetheless, they are mostly used as a way of fixing the risks of future price movements, but not without a speculative element.
- What distinguishes forwards from options is in the fact that forward contracts compel the parties to fulfill the transaction at the predetermined price and the set date.
Advantages
- Customization: A forward can be used to boil down a contract to bidder-exclusive one in case there is a special kind of asset which is non-standard.
- Price Certainty: Parties can establish a fair fixed price for future transactions, which become handy in an unstable economic environment.
- Hedging: Companies can use the forward contracts to lock-in the prices of future-living assets now, reducing risk in their portfolios.
Disadvantages
- Counterparty Risk: Forward market does not make it clear on which party will pay and which one will receive delivery, so some parties might end up defaulting leading to possible damages for the others.
- Lack of Liquidity: Spot commodities are entered into the market without the formality of standardized exchange-traded contracts and thus, they might be more challenging to exit or benefit from the upside.
- No Flexibility: Being the legally enforceable part of a sale, the entered forward contract abridges any possible flexibility to alter or cancel an agreement without the mutual consent of both parties.
Examples
- An enterprise executes a forward contract to buy the specific amount of crude oil at a specific price that are sixty months from now, being a stretch of time to balance increases in the price factor.
- A speculative investor can sell a forward contract on an index of stock to the other party, and save the selling price at a certain future date from the risk of a decline in the market.
- A multinational corporation does swap transactions beforehand in order to move from present value and give its exports and create an income stream liked to the future received value of the currency it is holding.
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