Forward trading is a transaction between a buyer and seller to trade a financial asset at a future date, at a specified price. The price of this asset and trade date is agreed beforehand as part of a forward contract.
A forward contract is a type of derivative product that shares similar characteristics to futures and options trading. This means that the contract’s value is based upon the stability of the underlying asset. For example, an exchange rate can affect the value of a currency pair, or political unrest can affect the value of a commodity, as seen in coal or oil trading.
Forward trading is an alternative to buying and selling at spot price, where an investor will physically purchase and own an asset based on its current spot price, with the intention of selling it later for a higher amount. The cash settlement takes place at the end of a forward contract period, as it has a pre-defined date of expiry. Trading forwards are often used as a hedging strategy to decrease the risk of losses when price movements are particularly volatile in a financial market, as traders can close out their positions before the delivery date of the underlying asset in return for cash.
Despite this expiry date, it is still possible to customize forward contracts as they are considered an over-the-counter (OTC) instrument. Customizable aspects include expiration date of the contract, the exact asset to be traded (for example a currency or commodity) and the exact number of units of the asset. You can also close positions early in order to minimize capital losses or take advantage of any profits.
Characteristics of a forward contract
- They are private, binding agreements between the buyer and seller.
- They cannot be traded on a centralized exchange but instead are traded over-the-counter instruments.
- They are non-standardized, meaning that they can be customized at any time throughout the trading duration.
- They are typically used within markets where spot prices are more common, for example, in the commodities market to trade popular raw materials such as oil, gas, corn, sugar, silver and gold trading. However, forward trading has more recently expanded to include currency forward contracts, indices and treasuries.
- They can be traded through CFDs.
Forward contract example
The value of a forward contract tends to vary as the value of the underlying asset increases or decreases. As an example, let’s say that an agricultural supplier is looking to sell 1000 barrels of white sugar in six months’ time that is valued at a total price of £10,000. The supplier is concerned for declining weather conditions in the country of produce that may have an effect on supply and demand, and therefore the price of the sugar. It agrees to a cash settled forward contract to sell the 1000 barrels to an international buyer for the spot market price of £10,000.
The spot price of sugar has three possible directions that it can turn after the six-month period: the value will remain the same, it will be higher than the contract price, or it will be lower than the contract price.
If the spot price remains the same at £10,000 for 1000 barrels of sugar, then the contract can be closed without anyone owing extra money..
If the spot price is now higher than the contract price, the supplier will owe the buyer the difference between the current spot price and the contracted rate.
If the spot price is now lower than the contract price, the buyer will owe the supplier the difference between the contracted rate and the current spot price.
What is the difference between futures and forwards?
Both futures and forwards offer a contractual agreement to buy and sell a financial asset at a set price in the future. However, while there are many similarities between the two trading contracts, there are some notable differences.
Futures contracts trade on a centralized public exchange and are standardized, meaning that their terms cannot be changed once a contract is made. On the other hand, forward contracts are more flexible in this respect. Their terms can instead vary from one contract to another. Cash settlement occurs at the end of a full forward contract, whereas changes are settled on a daily basis when trading futures until you reach the end of a contract.
Hedgers tend to trade forwards in order to avoid the volatility of an asset’s price, as the terms of agreement are set at the beginning of the contract. Any price fluctuations, therefore, will not influence the price at the end of the forward contract and traders can be confident with their starting agreed price. However, within the futures market, traders are able to take advantage of asset price fluctuations in the hope of making profit from their asset increasing in value. As these contracts are settled each day, both parties must ensure that they have the funds available to withstand the fluctuations in price throughout the duration of the agreement. As a result, traders will often close out the trade early and delivery will rarely happen, in the place of a cash settlement instead.
As futures are traded on an exchange, a clearinghouse involved guarantees the performance of a transaction, which is not available for forward trading. This means that a forward contract will be much more susceptible to credit risk and may default a transaction. The probability of default for a futures contract is almost never. This is why forward contract prices often include a premium charge for the extra credit risk.
Advantages and disadvantages of forward contracts
Forward contracts can be very popular with investors as they are unregulated by the government or Financial Conduct Authority (FCA), which means that they can be customised throughout the trade duration in order to meet buyer and seller’s specific needs. They also provide privacy and security for both the buyer and seller in their contractual agreement.
The binding nature of a forward contract can be seen as both an advantage and a disadvantage. On the one hand, the agreement to buy and sell at specific prices ensures that there is less risk due to market volatility, in the case that your asset value decreases throughout the contract period. However, some traders prefer to take advantage of these price fluctuations in the hope that their asset will increase in value. It may be more beneficial for these types of traders to look into a more flexible hedging strategy such as futures trading.
It can also be difficult to interpret trends and predictions for forwards trading as the size of the forwards market is unknown. As we have discussed, this may increase the likelihood of defaults on behalf of the counterparty, where the buyer is unable to make or finish their payments to the supplier. Large institutions usually measure this counterparty risk in advance to creating a forward contract, although this risk can never be completely eliminated.
Source: CMC Markets UK