A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. It is a non-standardized contract, which means that the terms of the contract can be tailored to meet the specific requirements of the buyer and seller.
The non-standardization component is what distinguishes a forward contract from a futures contract. As you know from previous discussions, a futures contract is highly standardized. This means that all contracts are exactly the same in terms of features and characteristics. For example, let’s examine a crude oil futures contract.
Crude Oil Futures Contract
- 1,000 barrels.
- West Texas Intermediate light sweet.
- Trading hours are Sunday through Friday (5:00 PM to 4:00 PM).
- The minimum price fluctuation is 0.01 ($10) per barrel.
- Delivery must occur before the last calendar day of the contract month.
- Must be delivered to a storage facility in Cushing, OK.
- Free-on-board delivery.
As you can see, a futures contract is heavily standardized in comparison to a forward contract. Generally speaking, speculators prefer standardized futures contracts. However, hedgers prefer the flexibility of forward contracts.
Risks of Forward Contracts
Does a forward contract carry more risk than a futures contract? Generally speaking, it does. The greatest risk with a forward contract is the default. Forward contracts are not traded on an organized exchange. Instead, trading occurs on the over-the-counter (OTC) market through a network of broker-dealers and large institutional investors. This type of trading arrangement creates a great deal of counterparty risk. Unlike a regulated futures exchange, OTC is basically unregulated with very little protection provided to the parties involved in the forward contract. For example, if a futures trader is financially unable to satisfy a margin call on a futures contract, the brokerage firm or the futures exchange is obligated to pay the margin call on behalf of the trader. This provides additional financial protection even if one party is unable to fulfill their financial obligation, while the OTC market does not provide such protection.
In addition to counterparty risk, the lack of liquidity increases the risk of forward contracts. Based on the fact that forward contracts are non-standardized, it can be very difficult for these instruments to provide adequate liquidity.
A clarifying example
So, let’s assume that Jane owns a large cookie company. Jane’s biggest expense is sugar, which is used to make her world-famous chocolate chip cookies. Jane believes that the price of sugar could be headed much higher because of poor growing conditions in the sugar-growing regions of Brazil. Therefore, she wants to purchase a six-month supply of sugar at today’s current price. Jane contacts her supplier. The supplier finds a sugar manufacturer who is willing to sell Jane a six-month supply. Jane enters a forward contract with the sugar manufacturing company. She agrees to pay for the sugar and the company agrees to deliver the sugar in six months.
Unfortunately, Jane’s cookie sales soon begin to decline. She discovers that she no longer needs a six-month supply of sugar. Unfortunately, she has very few options in terms of liquidating her forward contract. Why? Because the forward contract was created specifically for Jane and her business. In other words, it was a non-standardized contract. The sugar manufacturing company is under no obligation to buy the forward contract back. The only way Jane can liquidate the contract is by finding another buyer. Jane’s story is a perfect example of why forward contracts carry more risk than futures contracts.
Although forward contracts remain very popular in the hedging community, they will never reach the level of acceptance as futures contracts. Nevertheless, forward contracts will always play an important role in the financial ecosystem.
Brief Summary Of Forward Contracts
- Forward contract is a customized contract between two parties to buy or sell an asset.
- The asset is sold at a specified price on a future date.
- Forward contracts are non-standardized.
- Trading occurs on the over-the-counter (OTC) market through a network of broker-dealers and large institutional investors.
- Contracts can be tailored to meet the specific requirements of the buyer and seller.
- Non-standardization is the distinguishing characteristic of a forward contract.
- A futures contract is highly standardized.
- Hedgers prefer the flexibility of a forward contract.
- Forward contracts carry more risk than futures contracts.
- The greatest risk of a forward contract is default risk.
- Forward contracts are not traded on an organized exchange.
- The majority of forward contracts are illiquid.
- Futures contracts are more popular than forward contracts.