How Do Forward Contracts Work?

Introduction

Understanding how forward contracts work can be useful if you want to hedge against the risk of volatile markets. However, it can seem like ‘VIP’ knowledge given they’re not common in the commercial world. In this guide, we’re going to lift the veil and explain how forward contracts work. We’ll start by talking about what forward contracts and ‘over the counter’ derivatives (‘OTC derivatives’) are. We’ll also consider how forward contracts differ from futures contracts. Then, we’ll look at how forward contracts are used. Lastly, we’ll look at an example of how forward contracts work in a real-world context.

Overview of derivatives

Most forward contracts are a form of financial product called derivatives. Therefore, you need to understand what derivatives are before you can understand how forward contracts work. Under s 761D of the Corporations Act 2001 (Cth), a derivative is basically a transaction for some value based on an underlying asset, rate, index, or commodity. The transaction is typically the exchange of some underlying product (e.g. the asset itself). When transacting in a derivative, you would agree for this exchange to occur at some minimum amount of time into the future. OTC derivatives are pretty much only transacted between two private parties; this means that you don’t trade them on exchange markets (e.g. the Australian Securities Exchange). These characteristics will make more sense as we explain the mechanics of forward contracts. To learn more about derivatives generally, we recommend you consider getting financial or legal advice.

What are forward contracts?

Forward contracts, like most contracts, are private agreements between parties to buy and sell a product. However this product is actually exchanged at some specified date in the future. When entering forward contracts, you fix the price of this underlying product at the time of making the contract. While you fix the price with the other party, the value of the underlying product to the market can still change. Therefore, you can benefit from a value for the product in the future which is higher than the price fixed in the present. This is called taking the ‘long position’ (i.e. you are buying the underlying product); you are banking on the value of the underlying product increasing over time. If you are selling the underlying product, you are taking the ‘short position’, and are banking on the value decreasing over time.

Forward contracts v futures contracts

Forward contracts and futures contracts are very similar. However, forward contracts are OTC derivatives while futures contracts are just derivatives. To explain the difference between them in terms of more than just labels, we’ll look at two things: the nature of the two types of contracts, and the ability to trade them.

Nature of the contracts

As derivatives, both forward contracts and futures contracts provide for the exchange of an underlying product at some time in the future. However, forward contracts are unique to the buyer and seller negotiating them. As a party to a forward contract, you would set things like how many units of the underlying product you want. On the other hand, multiple independent parties can hold futures contracts for units of the same underlying product. Additionally, futures contracts are standardised, with each of these parties holding the same contract. This means they also hold the same amount of units of the underlying product. Forward contracts and futures contracts can also be available for the same underlying products. Therefore, which one you choose often depends on how specific you need the contract to be.

Trading the contracts

Another difference is the ability to trade the contracts. As we mentioned earlier, forward contracts are OTC derivatives. This means that you don’t trade the contract with others. However, you can trade futures contracts on exchange markets until the date specifying when the exchange of the underlying product must occur. For example, you can trade futures contracts for Australian grain on the Australian Securities Exchange (‘ASX’). Additionally, futures contracts are traded through licensed clearing and settlement facilities. These are facilities who provide mechanisms to ensure the obligations in futures contracts are fulfilled. On the other hand, you only have to clear certain forward contracts with licensed clearing facilities as prescribed by the regulations. Otherwise, you can just exchange the underlying product privately. As a result, for most forward contracts, you bear the full risk of the other party not fulfilling their end of the bargain.

Using forward contracts

if you are a retail investor, you can’t easily access forward contracts because they are executed privately and aren’t traded. Additionally, given the high risk involved, often it’s only big institutional investors who really use forward contracts. Some common underlying products in forward contracts include commodities like oil as well as currency. A good real world example of forward contracts are foreign exchange forwards.

Example: Foreign exchange forwards

Forward contracts to exchange currency in the future are sometimes referred to as foreign exchange forwards. You typically use this kind of forward contract if you have a business with a lot of foreign exchange exposure. For example, if you are an importer or exporter, you may deal with invoice payments in different currencies. You could therefore use a forward contract to fix the exchange rate for a particular amount of money you need to trade for foreign currency in the future. This amount would be the amount of the invoice. This allows you to hedge against the risk that the currency drastically changes against your favour before you pay the invoice. One place you could do this is at NAB Bank. According to their website, you can enter into foreign exchange forwards for transactions settled more than two business days after the initial agreement.

Conclusion

In conclusion, you can use forward contracts to exchange products in the future for a price fixed in the present. Most types of forward contracts are a form of derivatives. However, you should not confuse them with futures contracts; while you can trade futures contracts on exchange markets, you execute forward contracts privately with another party. As a result, forward contracts entail a lot of risk, and you mainly use it if you are a big institutional investor in things like commodities and currency, and wish to hedge against the risk of loss from the volatility in those markets.

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