Forward Contract A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at.

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Presentation transcript:

Forward Contract A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over the counter not on an exchange. A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time. If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if prices rise later, you will get only what your contract entitles you to.

Features of Forward Contract • traded over the counter (not on exchanges) • custom tailored • no money changes hands until maturity • non-trivial counter-party risk

Future contract versus Forward contract Exchange Traded Versus Private Agreements: forward contracts are private agreements, there is a high counter party risk i.e. a chance that a party may default on its side of the agreement. Futures contracts have clearing house that guarantee the transactions, which drastically lowers the probability of default to almost never. Settlement of Contract: Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract.

Speculation and Hedging Lastly, because futures contracts are quite frequently employed by speculator who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place.