Forward Contracts

Forward contracts are one of the main types of derivatives, which means that the value of the contract is derived from the value of the underlying asset (whatever the contract is based on). 

Table of Contents:

Simple Example

Its actually quite easy.  Imagine if you are trying to buy a book from Barnes & Noble, but they tell you that the book is not in stock, and that they can order if for you.  You agree.  You have just bought a forward contract with the book seller.  Meaning that you have agreed to give them money in the future in exchange for their "deliverable instrument", ie the book.  The book store that is selling the book has just sold you a forward contract, meaning that they are obligated to give you the book in the future when you bring them (the agreeed upon amount of) money.  You have agreed upon a price, and locked in that "contract" for a future delivery.  No cash changes hands until the final date when the product is delivered. 

• Book seller:  sold the futures contract -- sells the book (asset) in the future at a set price...must deliver the book (asset)  in the future at the agreed upon price. 
  • Note: if the market price of the book were to go down, then the book seller would be happy they locked in the higher price (the contract would be more valuable)
• Book buyer:  bought a futures contract -- buys the book (asset) in the future at a set price....must deliver money in the future.
  • Note:  if the market price of the book goes up, then the book buyer would be happy that they locked in the lower price (this contract would be more valuable). 

Business Examples:

Forward contracts happen every time that a business orders something, but must wait for delivery. 

Terminology

1.  Long - benefit if market price of asset goes up 

2.  Short - benefit if market price of asset goes down 

                      Forward     Type        when to use                                example

Book seller:       sells       short        if your hurt by price decrease     selling inventory

Book buyer:       buys       long        if your hurt by price increase       if purchasing for resale (and have fixed sales price)

*See the book seller example for derivatives  for an easy way to think about who is "long", and who is "short"

comparing futures & forwards:

Example, Foreign exchange currency contracts:

1. Futures are publicly traded on exchanges
2. Futures are traded in blocks.  With forwards, its easier to specify exactly the dollar amount that you want to trade.
3. Futures contracts expire at specified times (on the 3rd Wednesday of the quarter - March, June, September, December - and not in between.  So, if you are looking to hedge currency exposure till the middle of July, you might not choose to use futures contracts because the contract will expire in June, and would leave you naked (exposed) until July.
4. To buy/ trade futures contracts, an individual calls their stockbroker, who will require a "margin account" to insure against losses.  In forward contracts, the individual calls their bank, and makes a private deal with their banker.   No collateral is required, but you must have a bank that trusts you, and is willing to make the deal
5. Futures are not traded in every currency.  Look on the Chicago Merc exchange to see what is traded.  Usually its dollar, euro, yen, and other major currencies.  To trade less common currencies, it is sometimes difficult to find futures contracts traded on exchanges.  Instead, you will likely need to use a forward.
6. The good thing about Futures is that they trade on a very liquid market (easy to net out your position and trade your contract with someone else). 
7. Futures prices are quoted in daily papers, and online
8. There is a middle man, called a "clearing house" in futures contracts
9. Futures are "marked to market" on a daily basis, which results in many cash flows (daily), rather than just one big cash flow at the end (like with forward contracts)

See Also:

• forward exchange rate
• Foreign exchange Options