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What is a Forward Contract—Really?

By Megan Doyle

If there’s anything for sure about doing business, it’s that asset values—whether financial instruments like currencies or commodities like coffee and coal—are always fluctuating. These inevitable price fluctuations can greatly effect import-export business, especially for small and midsize enterprises (SMEs) that often lack the capital to safely absorb market risk. One way SMEs can hedge against such risk is to exploit the features of a forward contract. 

In essence, a forward contract is a type of private financial derivative in which two parties agree to make their trade on a future date at an agreed upon foreign exchange rate or commodity price. As Investopedia explains, a “derivative” is simply a contract whose value is based upon—or derived from—an underlying asset, such as the foreign exchange rate of a currency pair.1

 

Why Businesses Use Forward Contracts

 

Negotiating payment terms can be a difficult process for businesses. Terms favorable to the seller are often less favorable to the buyer, and vice versa. Payment terms can further be complicated by the fact that exchange rates and commodity values may change significantly in the time it takes to prepare, produce, and deliver goods and services. This means that either party in a trade deal may risk losing money if asset values shift out of favor, while the other party experiences a windfall.2

 

In extreme circumstances, exchange rates or prices can fluctuate so much that either the buyer or seller no longer wants to go ahead with the sale. Enter the forward contract, in which each party agrees on a specific exchange rate or commodity price in advance. In addition to helping protect businesses from the risks associated with market volatility, the features of a forward contract can also help SMEs plan and project cash flow with greater accuracy.

 

Noteworthy Characteristics of a Forward Contract

 

Forward contracts are private, binding agreements between each party in the deal. They are non-standardized and unregulated, meaning they can be customized to each party’s individual needs. This also means that forward contracts cannot be traded on a public exchange like futures contracts or options, which are highly standardized to enable trading. Forward contracts’ customization is a key feature.

 

To establish a forward contract, each party agrees on a set exchange rate or commodity price, and “delivery” date, or the date at which the exchange will be made. With a basic forward contract, the delivery date can be set as far as 12 months in the future.3 In other words, no money changes hands when the contract is established. This contrasts with a typical “spot” transaction in which the exchange is made immediately based on the current spot rate for the currency pair or commodity price.4 If a business enters a forward contract with a bank, it may have to pay an additional transaction fee.5

 

There are several variations of forward contracts. For example, “window forwards” feature delivery at any point between two pre-determined dates.6 Window forwards allow businesses to make multiple payments within the established window of time. Other types of forward contracts include long-dated forwards7 and non-deliverable forwards (NDFs).8 Long-dated forwards allow parties to set a delivery date up to 10 years into the future, whereas NDFs allow parties to exchange the difference in value between the two currencies, rather than the currency itself.

 

It’s worth noting that the binding nature of a forward contract means that users cannot take advantage of favorable shifts in asset values.9 For SMEs looking to retain the possibility of benefitting from market volatility, they may wish to look into a more flexible hedging strategy such as futures contracts or options.10

 

Forward Contracts in Practice

 

To help make the features of forward contracts clearer, here are two hypothetical examples.

 

A U.S. company recently acquired equipment from a Japanese technology company, and must pay 55,000,000 yen in 60 days. To hedge against foreign exchange risk in the next two months, the U.S. business decided to enter a basic forward contract with its bank. The forward contract states that the U.S. business will purchase 55,000,000 yen from its bank in 60 days at the current spot rate.

 

If the spot rate does in fact become unfavorable at the delivery date, the U.S. business will have hedged against its losses because it secured a more favorable exchange rate with its bank, and the Japanese company will be paid in full. Conversely, if the spot rate were to become more favorable after 60 days, the U.S. company would not be able to profit from the exchange rate movements because it is obligated to fulfill the forward contract with its bank.

 

The features of a forward contract for commodities are similar. A small-scale coffee farmer, for example, might plan to export coffee to a roasting company at $6 per pound, but expects the price of coffee to go down in the near future. To hedge against potential loss, the farmer might sell a forward contract to the roaster at $6 per pound. If the market price drops to $4.50 a pound, the farmer earns more than if the coffee sold at market price.11

 

The

Takeaway:

Market volatility may be an inevitable part of conducting business, but derivatives like forward contracts can help businesses hedge against potentially damaging asset value fluctuations. In addition to risk mitigation, the beneficial features of forward contracts include customizability and privacy.

Megan Doyle - The Author

The Author

Megan Doyle 

Megan Doyle is a business technology writer and researcher based in Wantagh, NY, whose work focuses primarily on financial services technology.

Sources

1. “What is a Derivative?,” Investopedia; https://www.investopedia.com/ask/answers/12/derivative.asp
2. “What is a forward contract against an export?,” Investopedia; https://www.investopedia.com/ask/answers/061615/what-forward-contract-against-export.asp
3. “Forward Contract Definition,” Investopedia; https://www.investopedia.com/terms/f/forwardcontract.asp
4. “Forward Rate vs. Spot Rate: What’s the Difference?,” Investopedia; https://www.investopedia.com/ask/answers/042315/what-difference-between-forward-rate-and-spot-rate.asp
5. “Forward Exchange Contract,” Accounting Tools; https://www.accountingtools.com/articles/2017/5/15/forward-exchange-contract
6. “Foreign Exchange Risk,” Export.gov; https://www.export.gov/article2?id=Trade-Finance-Guide-Chapter-14-Foreign-Exchange-FX-Risk-Management
7. “Long Dated Forward,” Investopedia; https://www.investopedia.com/terms/l/long-date-forward.asp
8. Understanding FX Forwards, Microfinance Currency Risk Solutions; http://www.microrate.com/media/docs/investment/V-Guide-to-FX-Fowards.pdf
9. “What is a forward contract against an export?,” Investopedia; https://www.investopedia.com/ask/answers/061615/what-forward-contract-against-export.asp
10. “Currency Options Explained,” Forex Traders; https://www.forextraders.com/forex-education/forex-fundamental-analysis/currency-options-explained/
11. “How Does a Forward Contract Work?,” Chron; https://smallbusiness.chron.com/forward-contract-work-18907.html

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