In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future
time at a price agreed today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. 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. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.[2] Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.[clarification needed]
A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. However, this also means it is more difficult to reverse a position, as the counterparty must agree to canceling the contract, or you must find a third party to take an offsetting position in. This also increases credit risk for both parties.
What are the uses of forward contracts?
A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future. No cash or assets are exchanged until expiry, or the delivery date of the contract. On the delivery date, forward contracts can be settled by physical delivery of the asset or cash settlement. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller. However, this also means it is more difficult to reverse a position, as the counterparty must agree to canceling the contract, or you must find a third party to take an offsetting position in. This also increases credit risk for both parties.
What are the uses of forward contracts?
Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of a scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset. Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices. For instance, coffee growers may enter into a forward contract with Starbucks (SBUX) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to make. Starbucks benefits from contract because it is able to lock in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of coffee ahead of time helps Starbucks avoid price fluctuations and assists in planning.
How do forward contracts work?
Forward contracts have a buyer and a seller, who agree upon a price, quantity, and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the agreed upon price and receives the agreed upon quantity of the asset. If the contract is cash settled, the buyer would have a cash gain (and the seller a cash loss) if the spot price, or price of the asset at expiry, is higher than the agreed upon Forward price. If the spot price is lower than the Forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset. A quick example would help illustrate the mechanics of a cash settled forward contract. On January 1, 2009 Company X agrees to buy from Company Y 100 pounds of coffee on April 1, 2009 at a price of $5.00 per pound. If on April 1, 2009 the spot price (also known as the market price) of coffee is greater
than $5.00, at say $6.00 a pound, the buyer has gained. Rather than having to pay $6.00 a pound for coffee, it only needs to pay $5.00. However, the buyer's gain is the seller's loss. The seller must now sell 100 pounds of coffee at only $5.00 per pound when it could sell it in the open market for $6.00 per pound. Rather than the buyer giving the seller $500 for 100 pounds of coffee as he would for physical delivery, the seller simply pays the buyer $100. The $100 is the cash difference between the agreed upon price and the current spot price, or ($6.00-$5.00)*100.
Risks of forward contracts
Because no money exchanges hands initially, there is counterparty credit risk involved with forward contracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled forward contract), if the counterparty defaultsbetween the initial agreement date and delivery date, you may have a loss. However, two conditions must apply before a party faces a loss: 1. The spot price moves in favor of the party, entitling it to compensation by the counterparty, and 2. the counterparty defaults and is unable to pay the cash difference or deliver the asset. 3. internationally you need to consider how you will protect yourself against changes in foreign exchange rates and other foreign exchange risks. A small variation in the rate could cost your business thousands of pounds if not managed properly. Our years of experience help to protect your bottom line and asset base.
4. At Currencies Direct we offer two types of forward currency exchange contract:
5. Fixed forward contracts
6. You take delivery of your forward currency on a specific date in the future.
7. Open forward contracts
8. You can take delivery of all the foreign currency at once, or drawn down smaller amounts as you need them - up to the amount of the value of the contract.
9. How does a Forward Contract work in practice?
10. Imagine you are a company with a need to purchase components worth 250,000 euros from a German supplier in 5 months time. Based on a GBP/EUR exchange rate of 1.20 EUR, you have determined that supplies will cost you today GBP 208,333, meeting your budget and cash flow constraints. On this basis you commit to purchase the components, and you agree to sell them to a client at a fixed price, generating GBP 10,000 of future profit to your business. 11. However, GBP might weaken against EUR during that five month period to a rate of 1.15, meaning that your cost would increase to GBP 217,390 . This would negatively impact your budget, cash flow and reduce your profit by GBP 9057 essentially eliminating all the profit margin.
12. In this case, if you booked a forward contract with Currencies Direct at the time you purchased the components you would have been able to secure the exchange rate of 1.20 , fix the cost to your business and avoid any unexpected impact on your profit margin. Of course, you would lose out if GBP strengthened against the EURO, but exposing your business to currency risks may have a long term effect , whereas if you buy forward you can guarantee an exchange rate based on where you cost the order. 13. Currencies Direct forward contracts can also provide flexibility enabling you to take delivery of your purchased currency in part or in full at any time between the contract date and maturity date. All companies with foreign currency exposures need a strategy to manage the risk. Call your dedicated dealer now who will tailor-make the contract to suit your business needs.
14.
Important information
15. If you do plan to book either a forward or time option contract you may be subject to additional security payments in the event of adverse exchange rate fluctuations. Such security payments must be received within 24 hours of notification. In the event you should have any questions please contact your dedicated dealer at Currencies Direct where they will be more than happy to assist. Further details and information is available to you please click here.
hree different types of forward contract
Time option forward contract This is a forward contract that allows access to the funds between two pre-determined dates eg. 01/04/00 31/08/00. This is of particular benefit when, for example a car delivery is not precisely known, and therefore funds may be needed earlier. It is important to remember that the last date is not flexible and physical delivery of the currency can take place before but no later than that date. Drawdown forward contract This is similar to a time option forward contract, however, if a portion of the funds are required during the life of the contract then they may be drawn down against the said contract at the original buy rate, thereby reducing the final balance. This would particularly suit either a boat or house purchase where large sums maybe needed to settle stage payments. Its structure also lends itself to corporate clients with large capital payments as the minimum is circa. 75,000. Draw down payments will incur a small fee. Fixed term forward contract A Fixed-Term Forward Contract gives you the ability to fix a currency rate with a view to take physical delivery of the said currency in the future. The rate is guaranteed irrespective of market fluctuations for the duration of the Contract. A deposit is required on each Forward Contract and must be received within two (2) working days of the contract date. The balance of the contract must be settled no later than the maturity date. We recommend that our clients settle the outstanding balance on their contracts five (5) working days prior to the contract matures. Should the delivery of the currency not be required upon maturity, the said currency can usually be held on account at no additional charge or penalty.
Types of Forward Contracts
Forward Rate Agreements (FRAs)
An over the counter, cash settled forward contract on interest rates, usually LIBOR (sort of the OTC equivalent of a Eurodollar futures contract). Confirmed agreement between two parties to exchange an interest rate differential on a notional principal amount at a given future date. A contract that fixes the interest now that will apply to a loan or deposit for a particular amount for a given period starting on a certain date in the future (the settlement date). FRA maturities usually correspond to Eurodollar time deposit maturities. The Seller of an FRA agrees to pay the Buyer the increased interest expense if the contract referenced LIBOR maturity interest rate is higher than the contract stipulated Forward rate (on the Settlement date / contract maturity). The principal amount is always referred to as the Notional amount. The Buyer of an FRA agrees to pay the Seller the decreased interest expense if the contract referenced LIBOR maturity interest rate is lower than the contract stipulated Forward rate (on the Settlement date / contract maturity). The principal amount is always referred to as the Notional amount. On the settlement date no actual principal is exchanged. Rather, the buyer and the seller calculate the present value of the net interest owed, and one party makes a cash settlement payment. The formula for determining the payment is: Payment = (N) (LIBOR - FR) (dtm / 360) / 1 + LIBOR (dtm / 360) (N = Notional Principal Amount) (LIBOR = LIBOR value on Settlement Date for the maturity specified by the contract) (FR = Forward Rate specified by the contract) (dtm = Days to Maturity of the Forward Rate) Example: Notional Amount of Principal: USD10,000,000 Settlement in One Month Forward Rate of 4% (four percent) on a Eurodollar Deposit, 90-days (three months) Actual 3-month LIBOR rate of 5% (five percent) on the contract Settlement Date As the LIBOR rate is higher than specified in the contract, Seller of the FRA owes the Buyer the difference between the 5% and the 4% interest on the Notional Amount for 90 days. Payment = (10,000,000) (.05 - .04) (90 / 360) / 1 + 0.05 (90 / 360) Payment = (100,000) (.25) / 1 + 0.0125
Payment = 25,000 / 1.0125 Payment = $24,691.36
Forward Currency Contract / Forward Exchange Rate
This is an agreement to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date (or between two pre-defined dates rather than a single maturity date). The value of the forward is derived from the the spot price and the interest rate differentials between the two currencies (which allows for the adjust for the time value of money). A forward currency exchange contract can extend out in excess of one year. The future value of currency is determined by: FV=P(1+r)n FV = Future value P = Principal r = interest rate per year n = number of years The future value of USD$ after one year when the interest rate is 3.250% is $1.03250 or FV=1(1+0.0325)1
Forward Gold Market
A mine may know that they will produce a certain tonnage in the next six months. They could enter into a forward agreement to sell this gold when it became available. Thus, the company will lock in the present gold price and hedge a decline in the price, and know what their income would be when planning production. Unlike a bond or a share, gold pays no interest or dividends. Starting from a neutral position the trader buys gold intending to sell it in one month. To buy the gold the trader has to borrow U.S. dollars (gold is quoted in dollars). When he sells the gold at the end of the month, he repays the loan, but he will be out of pocket to the extent of the interest charged on the loan. The price which he sells the gold at the end of the month must therefore be higher than the price paid for it to compensate the trader for the "cost of carry" which he has paid. That is why the forward price is usually higher than the spot price (premium).
A Commodity Non-Deliverable Forward is a forward contract that will be closed out and cash settled. The close
Definition
Probably the most simple form of derivatives, forward contracts are agreements to buy or sell at a certain point in the future an asset for a pre-specified price. Forwards are a common instrument to hedge the currency risk, when the investor is expecting to receive or pay a certain amount of money expressed in foreign currency in the near future. There are no costs in entering into a forward agreement apart from the differences in the bid-ask spread proposed by the financial institutions. A very important feature of the forward contracts is that these are binding contracts (contrary to options), and therefore both parts are obliged to honour the contract and deliver the asset at that price. This condition impacts the calculation of the payoff of the forward. Forward and spot prices are closely related. Assuming continuous compounding, we can determine the forward price of an asset as:
(1)
where and are the forward and the spot prices of the underlying asset respectively, is the risk free rate and is the period of time for compounding. This formulation implies there are no arbitrage opportunities. Note that if , speculators may buy the asset now and enter into a short forward agreement, fixing now the sale price at a later date. The inverse applies if . If the underlying asset is an investment asset which provides a known dividend yield, the above formula must be corrected to account for the rate of return of the investment, :
(2)
The initial cost of a forward contract is zero. Luenberger [3]: The forward price is the price that applies at delivery. This price is negotiated so that the initial payment is zero; that is, the value of the contract is zero when it is initiated. At each point in time, until maturity, the value of a forward contract with a delivery price of is calculated as:
(3)
When the contract is first established, the price of the forward contract is determined so as to ensure that its value is zero.
Forward exchange rate contracts
We can also define forward contracts on foreign currencies, where the underlying asset is the exchange rate, or a certain number of units of a foreign currency. We start be defining as the spot exchange rate and as the forward price, both expressed as units of the base currency per unit of foreign currency. Holding currency provides the investor with an interest gain at the risk-free rate prevailing in the respective country. If we take as the domestic risk-free rate and as the riskfree rate in the foreign country, the forward price is then as before:
(4)
This is known as the interest-rate parity. If this was not the case arbitrage opportunities would arise, forcing the prices back to equilibrium. If , a profit could be obtained by:
Borrowing in domestic currency at rate for time Buying of the foreign currency and invest this at the rate Short sell a forward contract on one unit of the foreign currency
At time , the arbitrageur will receive one unit of foreign currency from the deposit, which he sells at the forward price . From this results, he is able to repay the loan and still obtain a net profit of .
Hedging
Forwards on exchange rates are a commonly used hedging instrument for its simplicity and practicality. Suppose an US investor is expecting to receive in three months time the amount of Eur 150,000. Not wanting to take the risk of a depreciation in the exchange rate, he can enter into a forward rate agreement to sell Eur 150,000 in three months at the forward price of , therefore fixing the foreign exchange rate at the level . Forward contracts are quite effective when the agent knows exactly the amount he/she expects to receive at a future date, and allow him/her to hedge completely the risk of a change in the exchange rate. Nevertheless, while eliminating completely the risk of a currency depreciation, in
the opposite case the potential gain is lost as the exchange rate is already determined and is binding.
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Foreign currency and exchange risks
Forward foreign exchange contracts
One way to hedge against exchange rate movements is to arrange a forward foreign exchange contract. This is an agreement initiated by you to buy or sell a specific amount of foreign currency at a certain rate, on or before a certain date. Forward foreign exchange contracts are a secure and simple way of hedging when you're confident your deal will go ahead and the currency will be required. Imagine you will need to purchase components worth 100,000 from a German supplier in 12 months' time. One euro might currently be worth 90 pence, meaning the supplies would theoretically cost 90,000. However, if the euro increases in value against the pound to 95 pence over the year, the components would then cost you 95,000. If the euro is expected to increase in value, you might agree a forward foreign exchange contract to buy 100,000 for 92,000 on a specified date. Of course, you'll lose out if the euro falls in value. This solution suits almost all businesses that are at risk of losses stemming from adverse foreign exchange rates especially those who:
trade in a volatile market or to tight margins require large amounts of currency and so have a greater risk of losses resulting from unfavourable foreign exchange rates in relation to turnover
Advantages
You're protected against any adverse movements in the exchange rate. You can set budgets knowing exactly how much the transaction costs.
Disadvantages
You have to go ahead with the contract once you have arranged it, regardless of whether your circumstances change. Because the rate is fixed, you can't benefit from any favourable movement in the exchange rate.
Forward foreign exchange contracts can be arranged through all the major UK clearing banks or independent foreign exchange dealers and can be tailored to meet your specific requirements. Your bank or financial organisation should be able to advise you. The cost of a forward contract is usually built into the exchange rate.
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Subjects covered in this guide
Introduction Foreign currency issues when importing or exporting Identify foreign exchange risks Forward foreign exchange contracts Opening foreign currency accounts Opening an account with a bank overseas Buying currency options Foreign currency transactions and your bookkeeping
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more: http://wiki.answers.com/Q/What_are_the_advantages_and_disadvantages_of_forwar d_contract#ixzz1fI0z576D
A forward contract is an agreement between two parties to buy or sell a product at a certain price, but the purchase is not taking place until a future date. When a product is being sold immediately it is considered a spot contract. One advantage of a forward contract is that the current or today price is what the purchaser pays regardless of whether the price increases before the product changes hands. This can also be a disadvantage if the price happens to drop because the price cannot be changed once the contract is signed. For more information on forward contracts
Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of a scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset. Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices. For instance, coffee growers may enter into a forward contract with Starbucks (SBUX) to lock in their sale price of coffee, reducing uncertainty about how much they will be able to make. Starbucks benefits from contract because it is able to lock in their cost of purchasing coffee. Knowing what price it will have to pay for its supply of coffee ahead of time helps Starbucks avoid price fluctuations and assists in planning.
How do forward contracts work?
Forward contracts have a buyer and a seller, who agree upon a price, quantity, and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the agreed upon price and receives the agreed upon quantity of the asset. If the contract is cash settled, the buyer would have a cash gain (and the seller a cash loss) if the spot price, or price of the asset at expiry, is higher than the agreed upon Forward price. If the spot price is lower than the Forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset. A quick example would help illustrate the mechanics of a cash settled forward contract. On January 1, 2009 Company X agrees to buy from Company Y 100 pounds of coffee on April 1, 2009 at a price of $5.00 per pound. If on April 1, 2009 the spot price (also known as the market price) of coffee is greater than $5.00, at say $6.00 a pound, the buyer has gained. Rather than having to pay $6.00 a pound for coffee, it only needs to pay $5.00. However, the buyer's gain is the seller's loss. The seller must now sell 100 pounds of coffee at only $5.00 per pound when it could sell it in the open market for $6.00 per pound. Rather than the buyer giving the seller $500 for 100 pounds of coffee as he would for physical delivery, the seller simply pays the buyer $100. The $100 is the cash difference between the agreed upon price and the current spot price, or ($6.00-$5.00)*100.
Risks of forward contracts
Because no money exchanges hands initially, there is counterparty credit risk involved with forward contracts. Since you depend on the counterparty to deliver the asset (or cash if it is a cash settled forward contract), if the counterparty defaultsbetween the initial agreement date and delivery date, you may have a loss. However, two conditions must apply before a party faces a loss: 1. The spot price moves in favor of the party, entitling it to compensation by the counterparty, and 2. the counterparty defaults and is unable to pay the cash difference or deliver the asset.
