Forward contract (forward)
What is a forward contract?
Forward contract or forward - is a contract of purchase and sale or compulsory delivery of an asset chosen by the investor at a certain time in the future. In fact, a forward contract is a fixed-term contract that is necessarily executed by each party.
All terms and conditions of a forward contract are clearly and pre-established by the parties at the time of the transaction.
Why is a forward contact necessary?
A forward contract is generally concluded in order to make a real sale or purchase of the respective asset and to insure the supplier or the buyer against possible unfavorable price movements. Counterparties are insured against unfavorable developments, but they also cannot take advantage of possible favorable conditions.
Initially, this type of securities was used between sellers and buyers of raw materials, materials, etc. At the moment, a forward contract is also an exchange-traded speculative paper.
Despite the fact that the forward contract involves binding performance, the counterparties are not insured against the risks of non-performance due to, for example, bankruptcy or the bad faith of one of the parties to the transaction. Therefore, before entering into a transaction, partners should ascertain each other's solvency and reputation.
A forward contract may be entered into for the purpose of playing on the differences in the exchange rate value of assets. The person opening long positionThe person who opens a short position expects the price of the underlying asset to rise, and the person who opens a short position expects its price to fall.
By its characteristics, a forward contract is an individual contract. Therefore, the secondary market for forward contracts on most assets is not developed or poorly developed. The exception is the forward foreign exchange market.
Forward contracts on currency and interest rate
Forward contracts turn into derivative instruments as conditions of conclusion are standardized, i.e. partial refusal of their individuality, uniqueness of each individual contract, and at presence of the market intermediary (intermediaries or dealers), which becomes one of the parties of the forward contract with any other participant of the market. Thanks to such conditions there is a secondary market of corresponding forward contracts, or as they are also said, the latter become liquid contracts.
Liquidity forward contract turns it into a derivative instrument of the market, i.e. it allows to receive differential profit with its help, or, in other words, to use it for hedging and speculation purposes.
The main types of liquid forward contracts are:
- forward foreign exchange contracts;
- forward interest rate contracts.
In both cases, market intermediaries (dealers or market makers) are large banks serving the world market (currencies and credits). They set forward rates for buying and selling currencies with any maturity and conclude forward transactions, both for buying and selling currencies with market participants - clients among themselves.
The asset of an interest forward is not an ordinary asset (commodity, currency, security), but a bank or other interest rate. The income under this contract is the difference between the future (forward) interest rate, fixed in the contract, and the actual rate (spot rate) on the date of settlement of the contract.