Forward contract

Serious Information

A cash market transaction where a seller agrees to deliver a cash commodity to a buyer in the future. Unlike futures contracts, forward contracts are privately negotiated and not standardized.

The two parties must bear the other's credit risk, which is not the case with a futures contract. The forward price makes the forward contract have no value when the contract is written. However, if the value of the underlying commodity changes, the value of the forward contract becomes positive or negative, depending on the position held. Forwards are priced in a manner similar to futures.

forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. It is used to control and hedge risk, for example currency exposure risk or commodity prices (forward contracts on oil, gas). One party agrees to buy, the other to sell, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise no asset of any kind actually changes hands, until the maturity of the contract.
Some claim a forward contract is the simplest type of derivative.

The payoff from the forward is based on the actual price of the underlying asset on the delivery date. For example, let's assume that I enter into a forward transaction in which I agree to sell 100 pigs at £300 per pig in a year's time. If the price of a pig is £350 at the end of the year, I make a loss on the forward transaction because I must buy 100 pigs at £350 each in order to meet my obligation to deliver the pigs. On delivery I only receive £300 per pig, a total loss of £5,000 (100 x (£350 - £300)) plus delivery costs. On the other hand if the price of pigs has plummeted to £250 each, I profit £5,000.

There are two kinds of forward contract

Fixed Forward Contracts

Forward contracts protect your profitability and improve your bottom line by minimising foreign currency risk. A fixed forward must be utilised and settled on a specific date. It is useful when you have an invoice to pay or know that a payment will be received on a fixed date.

Open Forward Contracts

An open forward contract sets a window of time during which any contract can be settled as long as all of it is paid for by the final date. An open forward is designed for those who know they have a number of bills to pay in a certain currency and this gives them flexibility about what date they wish to use the currency.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually next business day). The difference between the spot and the forward price is the forward premium or forward discount.

A standardized forward contract that is traded on an exchange is called a futures contract.

The derivatives markets are financial markets for derivatives. The market is often divided into two, for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

A forward contract can be used in property trading locking the currency rate.

Most currency brokers will be able to offer you a simple forward contract, one of the most useful currency tools available to property buyers who have to make completion payments at some time in the future.

A forward contract allows you to lock into an exchange rate for a payment to be made in the future. So if we look at the example above, the buyer would have been able to lock into an exchange rate.

1851
The earliest "forward" contract for 3,000 bushels of corn is recorded. Forward contracts gain popularity among merchants and processors.

Quotes

"In no circumstances enter the derivatives trading market without first agreeing it in writing with me ... at some time in the future it could bring the world's financial system to its knees." Julian Hodge a Banker once said

We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." clamied Warren Buffett The world's greatest stock market investor, known as "the Sage of Omaha", in his Chairman's Letter in the Berkshire Hathaway 2002 Annual Report.

Former Federal Reserve Board chairman Alan Greenspan commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Commodities
Interested in trading commodities? Learn about what they are, the different types there are, and what purpose they serve in an investor's portfolio.

Some say deregulation of the forward contract industry allowed Enron to develop the scandal.

Forward contracting is used in agriculture in the USA the meatpacking industry asserts that forward contracts are necessary to allow sections of the industry to operate smoothly, to improve beef quality and to manage risk. The National Cattlemen’s Beef Association (NCBA) contends that the loss of forward contracts would increase market volatility for producers. Some vegetarians might be agains the idea for that then. A academic of Auburn University calculated that IBP’s forward contracts lowered cash market prices by five percent or $1.4 billion in 2003.

One can do a short forward contract (short term) or a long forward contract (long term).

In 2003 a bill was introduced in the U.S. House of Representatives that would amend the Packer & Stockyard Act to prohibit the use of forward contracts and formula pricing in the livestock sector.

http://www.metoffice.co.uk/

Links on websites on subject

http://www.federalreserve.gov/Boarddocs/testimony/2000/20000621.htm Testimony of Chairman Alan Greenspan on Federal Reserve Board's views on the Commodity Futures Modernization Act of 2000

http://www.ise.ie/index.asp The home page of Irish stock exchange

http://www.nasdaq.com/ The homepage of the stock exchange

http://www.cityequities.com/
http://www.moneyweek.com

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