Understanding Forward Contracts: How Forward Contracts Work

A forward contract is an agreement between a buyer and seller to lock in the current price of a commodity for sale at a future date. It is a type of derivative contract (an agreement between two parties for the future exchange of an asset) used by buyers and sellers in financial institutions to hedge against market price fluctuations. Forward contracts may be helpful in particularly volatile markets because they give both parties security in the exchange of a product at an agreed-upon price.

A forward contract ends at the contract's agreed-upon settlement date with cash or the delivery of assets. Forward contracts do not trade on exchange rates and are considered over-the-counter (OTC) agreements, unlike other derivatives such as futures which are based on the daily stock exchange. Buyers enter into forward contracts to mitigate the risk of an increase in the market valuation of a commodity.

Forward contracts are agreements between the seller and buyer of a commodity in the financial markets. A forward contract includes the commodity for sale, the amount of the commodity the buyer agrees to purchase, the commodity’s current price (or current spot price), and the end date of the contract. If the pricing of the commodity has not changed by the settlement date of the contract, the seller and buyer don’t have to exchange any money.

If the forward price (or price of the commodity at the end of the contract) has changed from the spot price at the contract’s settlement date, the financial institution will collect or pay the difference in valuation. If the forward rate of the commodity has risen, the seller owes the buyer the difference between the spot price and the forward price. If the delivery price has fallen, the buyer owes the seller the difference.

A forward contract is an over-the-counter, customizable derivative contract in which two parties agree on the price of a commodity for sale at a future date. Futures are also derivative contracts used in commodity trading that buyers and sellers use to guarantee the sale of a commodity, but they are settled at the end of each day. Though both are used to lock in the sale of a commodity, there are a few differences between the two.

1. 1. Forward contracts can be customized. Forward contracts are fully customizable between the parties, who decide on the commodity, the amount of the commodity to be exchanged, and the delivery date. Futures contracts are more standardized than forward contracts.
2. 2. They take place over different amounts of time. Forward contracts are settled at the agreed-upon end of the contract, which may be months in the future. Futures contracts are marked-to-market every day and are therefore settled day-by-day until the contract's expiration date.
3. 3. Commodity futures are traded on exchange. A forward contract does not trade on market exchange while a futures contract does. This means that futures contracts have clearing houses that ensure transactions are taking place.
4. 4. Futures are less risky. While not entirely risk-free, the futures market may have less default risk and credit risk than forward contracts because of the day-by-day settlement of the terms. Forward contracts are longer, and give either party more time to default on their agreement.

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