What is a Forward contract? Definition and examples

What is a forward contract? Definition & example

A forward contract is a contract between two traders based on mutual agreement, which basically entails the purchasing or selling of an asset at a future point of time, decided in advance. Hence, such contracts and derivatives are also sometimes referred to as futures. Still, these should not be confused with standard futures contracts, as these are highly elastic and advanced trading instruments. 

These financial instruments can be used to speculate on the market and predict its movement. This is difficult and requires extensive market research and fundamental analysis or is more akin to gambling if done uninformed, or can be used as instruments to hedge against other bets, to minimize risk. These hedging activities are best undertaken by larger entities like banks, cooperatives, and insurance companies.

Forward contracts carry the benefit of being derivatives, and hence you do not need to actually buy commodities or assets to perform trades. This also means they provide higher leverages generally but come with a greater amount of risk as well, requiring more finesse and market know-how in order to successfully execute profitable trade.

Forward contracts are highly modifiable and can be tailor-made to suit the exact kind of trade you want to perform, as it is inevitably an agreement between the seller and the buyer.

Real-life examples of forward contracts

Graphic of a forward contract

Forward contracts can accommodate almost any specific commodity, amount, delivery date, and expiry time, with hedging options opening up significantly because of these features. 

Forward contracts do not come under central depositories and trade as Over the Counter trading instruments, meaning that the agreement of validating the trade rests solely on the buyer and the seller, with some regulations and laws to ensure that trading is not plagued by scams.

For example, people who trade in agricultural commodities or other commodities are highly susceptible to several variables. Such trading options which the Forward Contract provides are perfect for hedging against unfavorable outcomes of the market, as it enables you the option to bet against or in favor of the market.

Like all derivatives and over-the-counter derivative products, Forward Contracts come with a higher probability of risk, owing to their decentralized nature and lack of extensive regulation. 

Forward contracts are not as easily accessible to the average retail investor as easily as it is to a bank or a hedge fund. An interesting example would be commodities traders that want to square off a deal at a “fixed” date or depending on achieved “conditions.” These are the two types of forwarding contracts.

Because of their potential risk, they are deemed to be difficult to operate as trading instruments and require a certain amount of knowledge of the markets and the ability to predict the movement of the market using research and analysis to consistently trade profitably.

Unlike Futures, which are short-term basis contracts based on mutual agreements that get cleared and squared off at max on a daily basis, Forward Contracts can be drawn up for months (even years in some cases) in advance and hence are inherently carriers of more default risk.

Forward Contracts provide interesting niche trading options for those whose situation benefits from sitting on positions for an extended period of time for a guaranteed payout.

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