Forward contracts

DEFINITION of Forward contract

The forward contracts or simply a forward in finance are non-standardized contracts between two parties to buy or to sell an asset. At a specified future time at a price agreed upon today, making it a type of derivative instrument.

WHAT IT IS IN ESSENCE

A forward contract is a contract that has a defined date of expiry. The contract can vary between different instances. Making it a non-standardised entity. Traders have to customize contract according to the asset being traded, expiry date and the amount being traded.

It is a contract between two parties to buy or sell an asset at a specified price on a future date. Traders can use such a contract for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.

Unlike standard futures contracts, a forward contract can be customized to any commodity, amount and delivery date. A forward contract settlement can occur on a cash or delivery basis.

This kind of contracts does not trade on a centralized exchange. And therefore they have value as over-the-counter (OTC) instruments. Their OTC nature makes it easier to customize terms. But the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.

As a result, forward contracts are not as easily available to the retail investor as futures contracts.

This kind of contracts have an agreed expiry on them. But that does not mean that they have to be kept open for the duration.

It is important to note that forward contracts also present a risk of price manipulation. Because a small transaction completed at an above- or below-market price could affect the value of a much larger forward contract.

HOW TO USE

This is a private agreement between two parties. Which is giving the buyer an obligation to purchase an asset at a set price at a future point in time.

You can trade grain, precious metals, electricity, oil, beef, orange juice, and natural gas. But foreign currencies and financial instruments are also part of today’s forward markets.

Most forward contracts can be closed early if you want to limit losses or take profits.