Know about forward contracts in business

With the development of stock markets and forward contracts, this has become a popular form of trading. Forward contracts are documents that record the sale of assets between a buyer and a seller. However, for many financial investors, this term is still quite new. To better understand the value and characteristics of this contract in business, follow the article below with Learn Forex Trading!

General information about forward contracts

Forward contracts are a type of financial security. Let’s learn about some of the characteristics of this type of contract through the following content:

What are forward contracts?

Forward contracts are a form of derivative securities. In which the buyer and seller conduct an asset purchase and sale transaction at a specific time in the future (forward date) at a pre-agreed price (forward price).

Different from spot contracts. Assets are usually delivered within 2 days from the signing date (T+2). Forward contracts have a longer delivery time. The difference between the futures price and the spot price is called a forward premium if the futures price is higher. Or there will be a forward discount if the forward price is lower.

This contract can be used to speculate on future prices. However, it is often applied to avoid future price or interest rate risks (hedging).

See more: What is inflation that has a strong impact on Forex?

What are the common types of contracts in the financial market? 

In today’s market, trading is often based on some popular types of Forward contracts. In the UK market, these participants are very diverse. Including banks, import-export companies, and financial institutions. Below are popular types of contracts on the market:

• Forward contracts on stocks: Based on stocks as the underlying asset of this type of contract.
• Forward contracts bond: Based on bonds as the underlying asset of this type of contract.
• Forward contracts commodity: Commodities such as coffee, rice, rice, and crude oil are the underlying assets of this type of contract.
• Forward currency trading contract: Represents an agreement to buy and sell a quantity of foreign currency at a specified future exchange rate.
• Fixed-rate contract: Agreement to pay interest at a future settlement date.
• Forward contracts do not trade: Payment is made in cash instead of transferring principal assets.

Main factors forming Forward contracts

Four main factors shape Forward contracts. Includes: the underlying asset, the parties involved, the future maturity date (maturity date), and the forward price that determines the settlement. Details are as follows:

1. Underlying assets for trading:

• Real assets, for example Soybeans, corn, coffee, wheat,…
• Financial assets, such as Bonds, stocks, currencies,…

2. Participating parties in the contract:

• Buyer (Long position): Agrees to buy an underlying asset at a decided time in the future at an agreed price at present.
• Short position: Agrees to sell an underlying asset at a decided time in the future at a price agreed upon at present.

3. Future maturity date (maturity date):

• Decided the period to make contract payments.

4. Term price or payment determination:

• Prices are based on spot prices and market interest rates. Is the price determined at present, applied to the underlying asset in the future?

  

Characteristics of Forward contracts

Forward contracts have the following basic characteristics:

• At the time of signing, the two parties did not make payments or exchange underlying assets. This activity will take place in the future at a specified time (due date).
• On the due date, the parties must perform their obligations according to the agreement. Even if the market price changes compared to the futures price.
• The contract is agreed and signed directly between the two parties without going through an intermediary, so there are no costs to pay.
• The underlying asset can be any type of asset. There is no need to standardize on volume, product quality or value.
• The contract is not listed and traded on the OTC (Over-the-Counter) market.
• The participant can close the position by opening an opposite position on a similar contract.
• No deposit is required.
• The liquidity of this type is low and has many potential risks.

Example of financial investment with forwarding contracts

In the UK, this contract can be traded based on commodities, foreign currencies, and stocks. Although not as popular as futures contracts. However, it is still possible to trade on some reputable and licensed exchanges. 

Example of a limited transaction: On February 1, 2023, Mr. A signed a contract to buy 1 ton of soybeans from Mr. B for 3 months (ie on May 1, 2023) for 10,000 thousand USD /kg. Mr. B is the seller, and Mr. A is the buyer. After 3 months, Mr. B must sell 1 ton of soybeans to Mr. A for 10,000 thousand USD. Mr. A must buy 1 ton of that soybean at the agreed price on February 1, 2023. Regardless of whether the market price changes after 3 months or not.

Compare Forward contracts and forex futures contracts

Can Forward contracts overcome the limitations associated with futures? and what is the difference between the 2 contracts? Let’s explore the specifics in the table provided

Alike 

• Type of derivative contract: Both belong to the type of derivative contract. That is, they create a commitment to buy or sell an underlying asset at a future date at a pre-agreed price.
• Partnership Principle: Both Forward contracts and Future contracts require commitment between the two parties involved. One side agrees to buy and the other side agrees to sell.
• Maturity Date: Both types of contracts have an expiration date. That is the point at which the contractual commitment must be fulfilled.

Different 

• Trading market: Futures are usually traded on the OTC (Over-the-Counter) market. While Forex futures contracts are usually traded on organized stock exchanges.
• Participants: During the term, participants are usually independent investors, banks, and financial institutions. Meanwhile, Forex futures contracts are typically traded by individual investors. Or business organizations that need to protect international transaction volumes.
• Payment: forward contracts usually have daily payments. While Forex futures contracts can have daily or end-of-term settlements.
• Type of underlying asset: In a forward contract, the underlying asset can be a commodity, stock, or interest rate. While Forex futures focus mainly on foreign currency trading.
• Regulation and supervision: Forex futures contracts are often more closely regulated. It is subject to stricter regulation due to the involvement of institutional exchanges. While Forward contracts often have more flexibility and fewer regulations.

  

Evaluate the pros and cons of Forward contracts

Advantage:

• The most important advantage of this contract is the ability to prevent risks and financial leverage. At the same time, it is an effective tool to stabilize a business’s income without being affected by asset fluctuations in the market. 
• Forward contracts are simply an agreement between two parties on how to trade goods in a particular way. So it is more flexible regarding factors such as deadlines, scale, and other conditions.

Defect:

• The first point to note is low liquidity. It increases the risk of this type of contract. Especially in payments between related parties. 
• Furthermore, participation is limited to just two parties – the seller and the buyer. If either party cannot perform the contract as signed. This can cause a lot of difficulties for users 
• In particular, the parties involved in the contract cannot change their positions before the expiration date. This also creates notable limitations.

See more: How to register ICMarkets broker account

Should you trade forex with Forward contracts?

Despite certain limitations, is still a tool used by many businesses, especially during the economic recession cycle. Aim to minimize unwanted risks. This helps them apply contracts in the reality of commodity markets

Businesses apply this contract to minimize risks when market prices have sudden fluctuations in the future. This contract allows them to fix the costs or income of the business in the future without worrying about price fluctuations in the market.

Conclude

Above is detailed information about Forward contracts. Through this article, Learn Forex Trading hopes that the article will help people better understand this type of contract and help them easily deploy and apply it in businesses when necessary.

Frequently asked questions

What are the advantages of a forward contract?

The main advantages of forward contracts include the ability to prevent risks, stabilize income, and be flexible in negotiating contract conditions.

How to reduce risks when using forward contracts?

It is important to understand the market, monitor price fluctuations, and ensure that the conditions in the forward contract are stated clearly and transparently.

Why should businesses use forward contracts?

Forward contracts help businesses stabilize income, minimize risks, and fix future prices, helping them better manage market fluctuations.