What Is a Forward Contract?

Image source: Getty Images.

Most investors concentrate on trades they want to make right now. However, some instruments allow two interested parties to plan out trades in the future. Forward contracts involve a buyer and seller who agree to take each side of a particular trade at a stated time in the future. Any type of asset can be involved, but the most common use for forward contracts is in the foreign currency markets. Forward contracts are similar to futures, but unlike futures, they are typically non-standardized. Parties can use forward contracts either to hedge positions they have elsewhere in their portfolios or for outright speculation on price movements of certain assets.

What a forward contract looks like

As an example, say you're interested in trading U.S. dollars for euros. You could go right now to a currency exchange facility and obtain euros for dollars currently. However, if you don't need the euros until the future, then doing the transaction early leaves you open to currency risk. At the same time, if you simply wait until later to go to the currency exchange facility, then you're also vulnerable to adverse movements in the exchange rate.

A forward contract for currency can eliminate these risks by setting a specific price that you'll agree to pay in the future. For example, you might agree to buy a forward contract wherein you'll trade $1,100 three months from now at an exchange rate of $1.10 per euro, obtaining 1,000 euros when the forward contract comes due. Between now and then, the exchange rate in the open market can fluctuate, but it won't change your arrangement under the forward contract. When the time comes, you can settle up by doing the currency exchange.

Alternatively, some forward contracts allow for cash settlement, which simply looks at the difference in between the market price at expiration and the price stated in the contract. In the above example, if the forward contract were cash-settled and the euro had risen to $1.20 by expiration, then you'd receive a cash payment of $100. That represents the $1,200 value of the 1,000 euros at expiration, minus the $1,100 that the forward contract calls for you to pay.

Downsides of forward contracts

One problem with forward contracts is that they don't settle every day. Therefore, there's no obligation for counterparties to keep a set amount of margin on hand unless the forward contract specifically calls for it, and that can increase the risk of default. If one counterparty fails to make good on the agreement, then the other counterparty often has no practical remedy, especially if a lawsuit for damages is unlikely to allow collection due to lack of assets.

In addition, forward contracts don't have a clearinghouse monitoring various parties. That also reduces the level of security involved compared to the much more regulated futures market.

Nevertheless, forward contracts can sometimes be useful. If you have a future need and want to lock in a certain price, then forward contracts can be a flexible way to get what you want.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!