Part 1: Forward Contracts
A forward contract is a private contract between a buyer and a seller in which the buyer agrees to buy and the seller agrees to sell a specific quantity of a certain security or commodity (known as the underlying instrument) at the price specified in the contract. The difference between a forward contract and most other sales contracts is that with the forward contract, the delivery and payment of the underlying instrument occurs at a specified future date instead of immediately. Let’s take a look at an example.
Before a wheat farmer plants his crop, he executes a contract with a cereal company for the delivery and purchase of 75,000 bushels of wheat at a price of $1 per bushel. The actual exchange of the wheat for money will, of course, not take place until after the crop is harvested in the fall. By entering into a forward contract, both the farmer and the cereal company reduce their respective risks. By pre-selling his crop at $1 per bushel, the farmer has protected himself against the risk that in the fall the then-current price (or spot price) will be lower than $1 per bushel. The cereal company, on the other hand, by pre-purchasing has protected itself against the risk that in the fall the spot price of wheat will be greater than $1 per bushel. Both parties to the transaction sacrifice the possibility of getting a better price for themselves in exchange for eliminating the risk of getting a worse price.
When harvest time arrives, the spot price will either be higher or lower than $1 per bushel depending on the normal circumstances that affect supply and demand. If the price at harvest has risen to, say $1.35 a bushel, the farmer will undoubtedly wish that he had not entered into the forward contract. The cereal company, however, will be quite pleased to pay a below-market price of $1 per bushel. On the other hand, if the spot price in the fall drops to $0.75 per bushel, the farmer will be delighted to be getting the above-market price of $1. The cereal company, of course, will not be so thrilled to have to pay $1 per bushel when the market rate is $0.75. In this contract, as with all forward contracts, the buyer is pleased if the agreed-upon contract price is lower than the spot price and the seller is happy if the contract price is higher than the spot price.
Because the forward contract is privately executed between the two entities, the primary goal when entering into it should be to ensure that all of the terms and contingencies are clear and that there are no uncertainties or ambiguities. Some contract parameters which should be clearly defined include: delivery terms and location, quality specifications of the underlying instrument, payment and credit terms (both parties are exposed to the risk of the other defaulting on its obligation), a dispute resolution procedure, cancellation provisions (the vast majority of forward contracts do not have such provisions), liquidity, and price transparency (which is the widespread availability of timely and accurate price information to any interested parties).
In Part 2 of this series, we’ll look closely at Futures Contracts.