What is a Forward Contract?

What is a Forward Contract?

It is a long-term contract between two parties to buy or sell an asset at a fixed price and on a specific date. The forward contract obliges its participants to buy or sell the investment at a price at a particular date in the future. 

It is built based on a certain underlying at its current price and financing cost. The most common are those traded in treasuries on currencies, metals, and fixed-income instruments. The main difference with futures contracts is that forward contracts are contracted outside organized markets, also called “over-the-counter operations. 

Forward contracts are simple and shared in all types of financial activities, and they don’t need to conform to the standards of a given market since they are considered OTC instruments. 

The buyer must acquire the merchandise at an agreed price and time in a forward contract. For its part, the seller agrees to deliver the goods. 

Modalities of the Forward Contract 

These contracts have three modalities: Those that do not generate profits. An example of this is that of oil since the storage of this product is costly due to the need to have unique installations against fires and pollution. 

Furthermore, oil is relatively cheap per unit volume, making storage costs necessary. Those that generate profits or fixed returns or dividends. These are the cases of forwards on bonds or shares. Those that create profits are reinvested. 

In this modality, they are those in which, for example, “a contract is signed with bank B whereby A and B agree to set a rate of 10% per year, for a term of one year, on the pre-established amount of money. 

After the year, if what A feared happens and interest rates drop to, for example, 8%, bank B will pay the difference between the agreed rate (10%) and the prevailing market rate (8%), that is, 2 % of the agreed amount of money. 

If, on the other hand, the rates rise to 12%, A must pay the difference to B”, as detailed by Rodriguez de Castro in his work “Introduction to the Analysis of Derivative Financial Products.” 

Usually, the usual thing is that these contracts are used in the third modality, that is, in currency operations. But for this operation to occur, the buyer and seller must be willing and open to negotiating. 

In addition, a reference parameter is necessary regarding the exchange rate and the financial costs of both countries during the operation. The contract price is stipulated based on each financial institution’s fees, and the premium is based on the risk of the counterparty, market situation, and profits. 

Delivery types Once the term is over, two types of delivery can be given: On the one hand, exchanging the merchandise for the previously agreed value. An exchange for or against cash is the difference between the agreed and final prices based on the current market situation.   

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