Forwards

A forward contract is an agreement between two parties to conduct a transaction at a specified rate and on a specified future date. Often, they are used in the commodity or foreign exchange market to let companies hedge against future price changes.

A forward contract is an agreement between two parties to conduct a transaction at a specified rate and on a specified future date. Often, they are used in the commodity or foreign exchange market to let companies hedge against future price changes.

A forward contract is a formal agreement between two parties, either individuals or businesses. The two parties to the contract agree to complete a specified transaction at a set price on a set date.

Forwards are traded over-the-counter rather than on an exchange. This means they are flexible. The two parties involved can customize things like their expiration dates or the amounts of the commodities involved in the transactions. However, the lack of an exchange and clearinghouse opens them up to additional risk.

An example of a forward contract would be two companies agreeing to a forward contract on June 1 that states that company A will sell 1,000 tons of grain to company B on Aug. 1 for $200 per ton.

How Forward Contracts Work 

Forward contracts exist mostly to give large businesses a way to hedge against changing market values for commodities and currencies.

Imagine a company that refines oil into gasoline and other products. The success of the company will depend largely on the price of oil. If oil is cheap, the company can make its products at a lower cost and secure higher profits. If the oil price rises, the company will need to accept less profit or raise its prices.

Because commodity prices can be volatile, it can be hard for a business to predict future prices and make long-term production decisions. Forward contracts let these businesses lock in their raw-material prices ahead of time.

Forward contracts can involve the exchange of foreign currency and other goods, not just commodities.

For example, if oil is trading at $50 a barrel, the company might sign a forward contract with its supplier to buy 10,000 barrels of oil at $55 each every month for the next year.

If the price of oil holds steady or drops, the company will lose money because it could have purchased oil for less on the open market. However, the business still has the benefit of knowing exactly what it will pay for the oil it needs far in advance. This makes financial planning much easier.