Forward Contracts

Forward Contracts 

In the dynamic world of investments, various financial instruments serve as valuable tools for managing risk and maximising returns. Among these instruments, forward contracts play a significant role in hedging strategies and investment planning. Forward contracts are versatile financial instruments that allow investors and businesses to manage risk, speculate on market movements, and secure future asset acquisitions.  

What is a forward contract? 

A forward contract is a customised agreement between two parties to buy or sell an asset at a predetermined price (the forward price) on a specified future date. The underlying asset can range from commodities like oil or wheat to financial instruments such as stocks, currencies, or interest rates. Forward contracts are bilateral agreements and are not traded on an exchange. Instead, they are negotiated and tailored to meet the needs of the contracting parties. It provides flexibility, allows risk management, and is subject to counterparty risk.  

A forward contract is customised to meet the specific needs of the involved parties, making it a flexible instrument in the world of investments. A forward contract is commonly referred to as a “forward agreement”. This flexibility allows parties to tailor the terms of the contract, including the size of the contract, maturity date, and the underlying asset. 

Understanding forward contracts 

Forward contracts are an integral part of the investment landscape, offering a valuable tool for managing risk and optimising returns. The key features of forward contracts are: 

  1. Customisation: Forward contracts offer flexibility in terms of contract size, maturity date, and underlying asset, allowing parties to design agreements that best suit their needs. 
  2. Obligation: Both parties are obligated to fulfil the contract upon maturity, regardless of the prevailing market conditions. This aspect differentiates forward contracts from options, where one party has the right but not the obligation to execute the contract. 
  3. Counterparty risk: As forward contracts are privately negotiated, they carry counterparty risk, meaning there is a risk that one party may default on its obligations. This risk can be mitigated through credit cheques or the use of intermediaries. 

Uses of forward contracts 

Forward contracts serve various purposes for investors and businesses. Some common uses include: 

  1. Hedging: Companies can use forward contracts to hedge against price volatility in the underlying asset. For instance, an airline may enter into a forward contract to buy jet fuel at a predetermined price to protect itself against future price increases. 
  2. Speculation: Investors can take speculative positions in the market by entering into forward contracts. If they anticipate a rise in the price of an asset, they can enter into a forward contract to buy it at a lower price, aiming to profit from the price difference upon contract expiration. 
  3. Cost planning: Companies involved in international trade can utilise forward contracts to plan their costs and budget effectively. By locking in prices in advance, businesses can forecast their expenses with greater accuracy. 

Risks of forward contracts 

While forward contracts offer advantages, they also carry inherent risks that should be carefully considered. Understanding these risks is crucial to making informed investment decisions. 

  1. Price risk: The main risk associated with forward contracts is price risk. If the market price of the underlying asset moves unfavourably, one party may face losses or missed profit opportunities. As forward contracts lock in a predetermined price, any significant deviation from the agreed-upon price can lead to financial implications. 
  2. Counterparty risk: As mentioned earlier, forward contracts are subject to counterparty risk. If one party fails to fulfil its obligations, the other party may suffer financial losses or face legal complications. To mitigate this risk, thorough credit cheques on counterparties are essential, and the involvement of reputable intermediaries can provide additional security. 
  3. Liquidity risk: Forward contracts lack the liquidity of exchange-traded derivatives, which can make it challenging to close out positions or find a suitable counterparty for early termination. 

Example of a forward contract 

To illustrate the application of a forward contract. Assume that the importer plans to purchase goods worth US$1 million from a supplier in the United States six months from now. The importer is concerned about potential appreciation in the USD/SGD exchange rate, which could increase the cost of the purchase. To safeguard against this risk, the importer decides to enter into a forward contract with a bank. The forward contract specifies that the importer will buy US$1 million from the bank at an agreed exchange rate of 1.35 SGD/USD in six months. This means that regardless of any future changes in the exchange rate, the importer is guaranteed to buy USD at the predetermined rate of 1.35 SGD/USD when the contract matures. 

There are two potential scenarios at the time of contract maturity: 

Scenario 1: Favourable exchange rate movement 

Suppose the exchange rate at the contract’s maturity is 1.40 SGD/USD. In this case, the importer benefits from the forward contract. By purchasing US$1 million at the predetermined rate of 1.35 SGD/USD, the importer saves 0.05 SGD per USD compared with the prevailing rate. This reduction in cost provides the importer with a competitive advantage and protects them from potential losses caused by an unfavourable exchange rate movement. 

Scenario 2: Unfavourable exchange rate movement 

On the other hand, let’s assume that at the contract’s maturity, the exchange rate is 1.30 SGD/USD. In this scenario, the importer incurs an opportunity cost of 0.05 SGD per USD. Although the prevailing rate is more favourable than the forward rate, the importer is obligated to purchase USD at the predetermined rate of 1.35 SGD/USD.  

By entering into a forward contract, the importer secures a fixed exchange rate, providing certainty in terms of cost and protection against unfavourable currency movements. This allows the importer to plan and budget effectively, eliminating the uncertainty associated with fluctuating exchange rates. 

  

Frequently Asked Questions

Forward contracts can be categorised as deliverable or non-deliverable. In deliverable forward contracts, the underlying asset is physically delivered upon contract maturity. Non-deliverable forward contracts settle the price difference between the forward price and the spot price at maturity without any physical delivery. 

Forward contracts are privately negotiated agreements, while futures contracts are standardised agreements traded on exchanges. Futures contracts offer more liquidity and are subject to daily mark-to-market settlements. 

  

 

 

  

 

A forward contract is a financial instrument used for hedging, which involves reducing or transferring risk. Hedging refers to strategies employed to offset potential losses or fluctuations in the value of an asset. 

  

 

Forward contracts involve two parties agreeing to buy or sell an asset at a future date and a predetermined price. Upon contract maturity, the buyer purchases the asset at the agreed price, regardless of the market price at that time. 

  

 

The main differences between forward agreements and futures contracts are their standardisation, trading venue, and daily mark-to-market settlement. Forward agreements are customised, traded over the counter, and do not require daily settlement adjustments like futures contracts. 

  

  

 

Related Terms

    Read the Latest Market Journal

    Introduction to unit trust

    Published on Apr 23, 2024 25 

    In the diverse and complex world of investing, unit trusts stand out as a popular...

    Back in Business: The Return of IPOs & Top Traded Counters in March 2024

    Published on Apr 17, 2024 482 

    Start trading on POEMS! Open a free account here! At a glance: Major indices continue...

    Weekly Updates 15/4/24 – 19/4/24

    Published on Apr 15, 2024 72 

    This weekly update is designed to help you stay informed and relate economic and company...

    From $50 to $100: Unveiling the Impact of Inflation

    Published on Apr 12, 2024 155 

    In recent years, inflation has become a hot topic, evoking strong emotions as the cost...

    Japan’s Economic Resurgence: Unveiling the Tailwinds Behind Nikkei 225’s Record Leap

    Published on Apr 11, 2024 87 

    Source: eSignal, Intercontinental Exchange, Inc. In the heart of Japan’s economic landscape, the Nikkei 225...

    Weekly Updates 8/4/24 – 12/4/24

    Published on Apr 8, 2024 109 

      This weekly update is designed to help you stay informed and relate economic and...

    What Makes Forex Trading Attractive?

    Published on Apr 2, 2024 191 

    In a world where the click of a button can send goods across oceans and...

    Weekly Updates 1/4/24 – 5/4/24

    Published on Apr 1, 2024 99 

    This weekly update is designed to help you stay informed and relate economic and company...

    Contact us to Open an Account

    Need Assistance? Share your Details and we’ll get back to you

    IMPORTANT INFORMATION

    This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.  

    An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.  

    Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.  

    Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.  

    The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <www.phillipfunds.com> for more information in relation to the dividend distributions.  

    The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.  

    The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published. 

    This advertisement has not been reviewed by the Monetary Authority of Singapore.  

     

    Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)  
    250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101 
    Tel: (65) 6230 8133 Fax: (65) 65383066 www.phillipfunds.com