Forward contracts, or forwards, are customized agreements between two parties to buy or sell an asset at a predetermined price on a specified future date.

Forwards are not like the futures contracts, but they are privately negotiated and traded over-the-counter (OTC) and that offers flexibility in terms but also introducing unique risks.

What is a Forward Contract?

A forward contract is a financial instrument tailored to meet the specific needs of the contracting parties. It involves:

1. Buyer: Agrees to purchase the asset at the set price.
2. Seller: Agrees to deliver the asset at the set price.

Forward contracts can cover a wide range of assets, including commodities, currencies, and financial instruments. They do not involve daily settlements like futures but are settled at maturity.

In 2020, during the COVID-19 pandemic, airlines entered forward contracts to purchase jet fuel at fixed prices, hedging against future price surges as the economy recovered.

Similarly, exporters and importers use currency forwards to manage exchange rate risks when engaging in international trade.

Features of Forwards

1. Customization
Forward contracts are highly flexible, allowing parties to negotiate terms such as quantity, quality, price, and settlement date.

2. OTC Trading
Forwards are traded in decentralized, over-the-counter markets rather than on regulated exchanges.

3. Non-Standardized
Each forward contract is unique, tailored to the requirements of the buyer and seller.

4. Settlement at Maturity
Forwards are settled on the agreed future date, with either:

• • Physical delivery: The asset is exchanged.
  • Cash settlement: The price difference is paid.

5. No Daily Mark-to-Market
Unlike futures, forwards do not involve daily adjustments for market price changes.

How Forwards Work

Example: Currency Forward

A U.S.-based company expects to receive €1,000,000 in three months. To avoid the risk of euro depreciation, it enters a forward contract to sell €1,000,000 and buy USD at an agreed exchange rate of 1.10.

• If the euro depreciates to 1.05, the company is protected by the 1.10 rate.
• If the euro appreciates to 1.15, the company still sells at 1.10, foregoing potential gains.

This forward eliminates uncertainty, providing a predictable exchange rate for the company’s cash flow.

Why Use Forward Contracts?

1. Hedging

Forwards are primarily used to mitigate risks associated with price fluctuations in:

• Commodities (e.g., oil, wheat).
• Currencies (e.g., USD, EUR).
• Interest rates.

2. Speculation

Investors or traders use forwards to speculate on future price movements without owning the underlying asset.

3. Flexibility

Forward contracts can be structured to meet specific needs, offering terms that may not be available in standardized instruments like futures.

Forward vs. Futures

Types of Forward Contracts

1. Commodity Forwards

Used by producers and consumers to lock in prices for raw materials or goods (e.g., farmers hedging against crop price volatility).

2. Currency Forwards

Commonly used in forex markets by businesses and investors to manage foreign exchange risk.

3. Interest Rate Forwards

Help institutions hedge against interest rate changes.

Equity Forwards
Allow investors to gain or hedge exposure to stock prices without owning the underlying shares.

Advantages of Forward Contracts

1. Flexibility
The ability to customize contract terms makes forwards ideal for unique requirements.

2. Hedging Capabilities
Businesses can protect themselves from adverse price movements, ensuring more predictable financial outcomes.

3. No Initial Margin Requirement
Unlike futures, forwards typically do not require an upfront margin, reducing immediate cash flow impact.

Risks of Forward Contracts

1. Counterparty Risk

Since forwards are OTC agreements, there’s a risk that one party may default on their obligations.

2. Liquidity Risk

Forward contracts are not as liquid as exchange-traded instruments, making it harder to exit or adjust positions.

3. Mark-to-Market Risk

Although not settled daily, price changes can result in significant obligations at maturity if the market moves unfavourably.

4. Lack of Transparency

OTC trading lacks the price transparency of regulated exchanges, potentially leading to unfavorable pricing for one party.

Applications of Forwards

1. Corporates

Multinational companies use this contract to hedge foreign exchange exposure when conducting cross-border transactions.

2. Agriculture

Farmers and food companies use commodity forwards to stabilize income and costs amid volatile market conditions.

3. Financial Institutions

Banks and hedge funds employ forwards to speculate on interest rates or currencies and manage portfolio risks.