A forward contract is a binding agreement between two parties to trade an asset with an agreed upon price at a set time. Its opposite is a spot contract which is a trade agreement that occurs almost instantaneously, there and then.
No money is exchanged during the initialization of the contract. Money is exchanged during the termination of the contract. We conclude that the settlement only occurs at the expiration of the contract.
Forward contracts are traded Over-the-Counter (OTC) not in an exchange. This is primarily because of its non-standardized nature which causes its illiquidity too.
The contract must be honored. It is therefore an obligation to carry out the trade. The risk therefore, is only dependent on the counter-party. To manage counter-party risk, each party must evaluate the default risk of the other party prior to entering the contract. Suppose the default risk of a party is high, then obtaining a performance bond is guaranteed by an insurance company to ensure delivery on the contract at the specified time provided that a party defaults.
Since a forward contract is a contract, it is legally binding. You will find it specified under contract law.
The main difference between forward contracts and future contracts is that a forward unlike a future is not transferrable, is non-standardized, is illiquid, and is exposed to counter-party risk. This essentially means that both parties are in a customized contract whereby the parties are fixed and cannot change. A futures contract on the other hand can change hands, which means the parties are not fixed.
The one who will buy the asset at the specified time is in the long forward position, a position of ownership. Meanwhile, the one who will sell the asset at the specified time is in the short forward position. During the settlement of the contract at the expiration time, one party will gain and the other will lose relative to the spot price (price of the underlying asset at the time of expiry).
What are forwards used for?
A forward contract protects the buyer against price increases and the seller against price drops. This quality makes it suited for risk management, where you can use them for hedging. It is also used for speculation — but is more suited for hedging.
Hedging is a term used to describe the use of financial instruments to reduce future risk or loss. This is done by locking in the price of an underlying asset to gain certainty of the future financial outcome.
The current price of the underlying is known, but the future price isn’t known. It is this understanding that justifies forwards use for risk management purposes.
A little bit of history
Forward contracts first appeared in Mesopotamia at the hand of the Babylonian King Hammurabi in his code of law which he used to govern Babylon from 1754 BC onwards.
Tailormaking a forward contract
Recalling that a forward contract is non-standardized, this is because a forward contract is highly customizable and therefore we can tailor make the terms of the contract.
Every forward contract must have these terms specified:
- The underlying asset
- the quantity (size of contract) of the underlying asset to be delivered
- The expiration date of the contract
- The contractual obligation
- The forward price
- type of settlement: cash settlement or physical settlement (then logistical specifics must be mentioned)
Types of underlying assets:
- Commodities
- Interest rates
- Stocks
- Economic factors
- Currencies (FX)
Types of Forward Contracts
We can categorize the types of forward contracts on two bases: underlying asset and structure of forward contract.
Major types of underlying asset forward contracts:
- Commodity forwards
- Interest rates forwards
- Currency forwards
Major types of forward contracts based on structure:
- Non-deliverable forward
- Long-dated forward: independent of whether it is flexible or closed, it is a contract that is held to be executed at a long time in the future. Its opposite is the short-term forward.
- Flexible Forward: can execute the contract before or on the date of expiration
- Closed forward: when the rate is fixed
- Naked forward
How to price a forward (price) contract?
We ought to use the no-arbitrage principle. You can brush up on what arbitrage is by checking out this article:
To begin to mathematically model a forward contract we must utilize the following assumptions:
- No arbitrage
- No transaction costs
- There is a risk-less investment such as cash in a bank account earning interest or a bond
- All asset prices are fair prices; this assumption comes from the bigger assumption that the markets are efficient
Now let us introduce a precise definition of a forward contract with some relevant notation;
A forward contract is a binding agreement between two parties to buy or sell an (underlying) asset for a certain price Kat a certain time in the future T.
Let’s visualize the basic flow of what happens at the agreement and settlement of a forward contract:
We ought to then define forward price more precisely as F(t,T) where the current time t ≤ T. By definition each party can either go long or short at t, such that K=F(t,T). The price of the asset at expiration can therefore be expressed as ST=F(T,T). The payoff function at the current time t is VK(t,T)=0, this means that the forward contract has zero value at time t. VK(t,T) is essentially the value how much a contract itself is worth in the long position at time t and a certain price K.
Since in a long position a forward contract must pay K at T to buy an asset worth ST we have VK(T,T) = ST — K. The reverse, the short position, would have VK(T,T) = K — ST.
In words,
The payoff from a long position = price of asset at expiration — forward price
The payoff from a short position = forward price—price of asset at expiration
To demonstrate how to price a forward contract, we will use an example whilst proving using replication.
You are a company based in the UK who has a branch in Kuwait and you would like to sell one KWD (Kuwaiti Dinar) in one years time:
The final solution for K is how we shall price the forward. We can generalize that solution for every asset that pay no income. It is important to note that payoffs are profits realized.
Conclusion
Forward contracts are one of the most oldest and simplest financial derivatives available. As a business owner, they guard you against price fluctuations and as a trader they could benefit you in speculation (or possibly in an arbitrage opportunity). The advantage of entering a forward contract is that it allows for certainty but could lead to opportunity losses. Forward prices for assets that pay no income are determined by the growth factor of an asset price to the time of expiration/maturity.