Forward contract

A forward contract is a specialized financial agreement between two parties. In this contract, the parties agree to buy or sell an asset at a specific time in the future. They also agree on the price at the moment they sign the deal. This set price is known as the delivery price. Because the value of a forward contract comes from an underlying asset, it is classified as a derivative instrument.

In every forward contract, there are two distinct roles. The party that agrees to buy the asset in the future takes a long position. The party that agrees to sell the asset in the future takes a short position. The price of the underlying asset is paid before the actual control of that asset changes hands. This is different from many other trades where the trade date and the value date are the same. In a forward, the time of the agreement and the time of the exchange are separated.

People use these contracts for several different purposes. One common reason is to hedge risk. Hedging is a way to protect against changes in prices, such as currency exchange rates. For example, a person might use a currency forward to lock in a rate for Canadian dollars. This helps them if they have a debt to pay in that currency later. Another reason is speculation. A speculator uses a forward contract to make a bet on future prices. They hope to profit by correctly guessing how the market will move.

Setting the delivery price requires careful calculation. This is often done using a concept called spot-forward parity. This principle links the current market price, called the spot price, to the forward price. One way to look at this is through the cost of carry. The cost of carry is the net cost of holding an asset versus holding a forward contract. This includes the risk-free rate of return, which is the interest earned in a bank. It also includes other factors like storage costs or income.

Different types of assets change how the price is calculated. Investment assets, like gold, may have storage costs. These costs act like negative income because they make holding the physical item more expensive. Some assets, like stocks, provide income or dividends. When an asset pays income, the forward price must be adjusted to reflect this benefit. This ensures that the contract is fair compared to buying the asset immediately. The math must account for whether this income is paid at specific times or continuously.

Raw materials like crude oil or iron ore are called consumption assets. These assets are used in production or for energy. People who hold these physical assets may enjoy a convenience yield. This is a non-cash benefit from having the actual material on hand. A high convenience yield often happens when inventories are low. This reflects the market's expectation that there might be a shortage. If inventories are high, the convenience yield is usually lower.

Economists have studied how these prices relate to future expectations. John Maynard Keynes and John Hicks discussed how different people use these markets. They noted that hedgers often take short positions to reduce risk. Speculators often take long positions because they want to make a profit. This can lead to two market states: contango and normal backwardation. In normal backwardation, the forward price is lower than the expected future spot price. In contango, the forward price is higher than the expected future spot price.

Forward contracts are different from futures contracts in important ways. Futures are standardized and traded on official exchanges. Forward contracts are traded "over the counter," or OTC. This means they are private deals that can be customized to specific needs. However, OTC trades come with counterparty risk. This is the risk that the other person might not fulfill their part of the deal. Because they are private, it can also be much harder to close out a position or cancel the contract.