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- AuthorJack Woerner
BA in Political Science with Emphasis on Social Studies Education at Brevard College, 6 years experience (2 years online) teaching Economics, Personal Finance, APUS Government and more. Certified Gifted/Talented Teacher.
View bio - InstructorElizabeth Branum
- Expert ContributorSteven Scalia
Steven completed a Graduate Degree is Chartered Accountancy at Concordia University. He has performed as Teacher's Assistant and Assistant Lecturer in University.
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Learn the definition of a forward contract. See what a forward contract is used for, how one is settled, and possible risks. Review examples of forward contracts.Updated: 11/21/2023
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Forward Contracts - A Practical Exercise:
The following exercise is designed to help students identify and interpret forward contracts in a real-life business context.
Scenario
You are the Chief Financial Officer of Boomer Farms, a company that harvests its agricultural produce and also makes packaged food products (e.g., frozen fruit, frozen potato fries, etc.). During the year, your Vice President of Finance performed the following transactions which you wish to examine.
| No. | Transaction |
|---|---|
| 1 | Boomer Farms agreed to deliver 1 ton of potatoes to McCain in 2 years at $1 per lb. This contract was signed so that the company can "lock-in" a specific price. |
| 2 | Boomer Farms signed a contract that gave it the right, but not the obligation, to buy 3 tons of apples from another farm. This contract was signed so that the company can keep its options open if ever it wanted to produce applesauce. |
| 3 | Boomer Farms signed an agreement with BP Oil to receive 10,000 liters of gasoline in 12 months at a fixed price of $0.97 per liter. This was signed in order to reduce the company's exposure to volatile oil and gasoline prices. |
| 4 | Boomer Farms signed a purchase order for 2 tons of watermelon that were delivered the same day. |
Required
For each contract, answer the following questions:
- Is this contract a forward contract in nature?
- If it is a forward contract, what was the reason for the agreement (i.e., hedge versus speculative)?
Solution
| No. | Forward Contract? (Yes/No) | Reason |
|---|---|---|
| 1 | Yes | Hedge (i..e reduces risk) |
| 2 | No - Option contract | N/A |
| 3 | Yes | Hedge (i..e reduces risk) |
| 4 | No - goods already delivered | N/A |
Why do people buy forward contracts?
Two main reasons people buy forward contracts are speculation and hedging. Speculation is someone taking on risk to earn a big return on an investment opportunity while hedging is making a transaction to possibly limit or reduce risk.
How does a forward contract work?
A forward contract works by two parties entering into an agreement to trade an asset at a specified date and price. When that date arrives, the cash and the asset will exchange hands.
Can a forward contract be sold?
Yes, a forward contract can be sold to another party. This would occur only if the contract terms allowed, but the third party would assume the terms, risk, and responsibilities from the previous contract.
Table of Contents
- Forward Contract Definition
- Forward Contract Examples
- Forward Contract vs. Future Contract
- Lesson Summary
What is forward contract? The forward contract definition in financial investing is an agreement that an investor will purchase an asset at a set price on a specific future date. Forward contracts can also be shortened to just "forwards" and are often known as a "pay now, buy later" agreement. The forward contract involves one party willing to buy an asset at the future date and another party selling the same asset when that specific date arrives. For example, an investor enters into a forward contract to purchase 10 euros at a price of 15 US dollars today. The person selling 10 euros will deliver the assets on the agreed upon date.
Forward contracts are usually traded in secondary markets between participating parties and not very common on centralized markets. These secondary exchanges are used primarily because the forwards are customizable to individual agreements.
What Is a Forward Contract Used For?
Forward contracts are used mostly in secondary markets, especially foreign currency exchanges (FOREX). Foreign currency exchange markets are where various currencies are bought and sold.
There are two main reasons why an investor may consider a forward contract:
- Speculation - This occurs when an investor takes on substantial risk in an investment but anticipates a larger gain.
- Hedging - This is when an investor enters into a contract in order to reduce the risk of loss from another investment.
 |
Risk Associated With Forward Contracts
As with any type of investing, there are financial risks. The primary risk associated with forward contracts is the possible loss of money in speculation. The market can be unpredictable and present a large financial loss to the investor. Since the price has already been agreed upon, if the value of the asset drops way below, the investor still has to pay the previously set price. In most forwards, a cash deposit is required to solidify the deal. An investor also runs the risk of having to pay a premium fee to execute the contract. The volatility of FOREX trading has led to even more risk for forward investing. The increase in international trade has created an enormous market for hedging with forward contracts for the purpose of minimizing foreign exchange risk.
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Using forward contracts to invest in commodities, facilitating international trade, and asset speculation are all common forward contract examples.
Commodity Trading Forward Contract Example
Fred enters into a forward contract with Frank to buy 1000 pounds of wheat. Frank sets the price at a $10,000 cash settlement to be paid in one month at the contract's expiration date. When the settlement date arrives, the market value for 1000 pounds of wheat moves up to $15,000. Fred only has to pay $10,000 because of the forward's cash settlement agreement and owes nothing to Frank. Not only does Frank have to give Fred the wheat, but he also has to pay Fred the $5,000 difference between that market price and the contract price.
 |
Foreign Currency Exchange and Speculation Contract Example
Sarah is a FOREX speculative day trader and enjoys the rush of buying or selling foreign currencies. She has been researching and speculating that the price of Japanese yen to increase in the next few months and wants to take advantage of this. However, Sarah is worried that unprecedented events can negatively impact her transaction. Sarah enters into a forward contract to purchase 100,000 yen in three months at the set price of $500 US dollars. When the three months' contract date arrives, she will need to pay the holder of the yen $500 and she will receive the 100,000 yen, even if it goes up or down in value.
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