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