About Forward Contracts

A forward contract is a type of non-standardized derivative instrument involving the purchase of a given asset at some future date. The purchase price, or forward price, is determined in advance. A forward contract is different than a spot contract (another non-standardized or over-the-counter investment involving the immediate purchase of a good), as well as a futures contract (an agreement to buy a good in the future, but one which is traded on a regulated stock exchange).

Like a futures contract, a forward contract involves two parties settling on a buying price for a good in advance of the actual transaction. Typically, a smart seller is gambling that the price will fall in the intervening time period, so that he or she will make a higher profit by setting a price in advance than by waiting. In the same way, a smart buyer is gambling that the price will rise in the same time period, so that he or she will get the asset at a lower price.

Forward contracts are common in the largely unregulated derivatives market, but the principle behind them can be understood through a simple example. Suppose that Diane has decided she wants to sell her house when she moves to a new town in a year’s time, but is concerned that house prices are going to fall in the meantime. In contrast, couple Liam and Melissa want to buy a new house in the same time frame, already have cash ready, but are concerned that house prices are going to rise. Diane may agree to sell her house to Liam and Melissa at a value (say, $200,000) which all three think is to their advantage. In other words, Diane gambles that housing prices will fall so that her house is worth less than $200,000, and Liam and Melissa gamble that the prices will rise so that the house is worth more than $200,000. If prices go up, then Liam and Melissa “win,” buying the house at a lower price than it is technically worth. However, if prices go down, then Diane wins, and sells the house at a higher price than the market says it is worth.

The same principle is at work in forward contracts in the derivatives market, although the assets being exchanged can be somewhat more esoteric than a house. A forward contract may be negotiated involving currency or anything else. In each case, much like futures, it amounts to a gamble in which the seller in effect predicts that prices will fall, and the buyer predicts that prices will rise. If prices remain stable, then neither party gains significantly from the transaction, unless the initial price was already determined on the basis of some sort of assumed change.

In addition to being an investment vehicle in its own right a forward contract can also be used to hedge against other investments. Alternatively, it can be used to supply stability in an uncertain market environment by arranging prices of an asset in advance of a transaction.