If a farmer plants wheat, then, at some point, the farmer will wish to sell that wheat. To make a profit, the farmer must sell the wheat for at least a minimum price to cover costs and to cover the opportunity cost of growing the wheat. Since most agricultural products are sold in a purely competitive market, the farmer has no power to set the price; instead, he must accept the market price at the time of delivery. If the price is too low, then the farmer will suffer a loss.
On the other hand, a baker must buy wheat to produce her product. Like the farmer, the baker must accept the market price, which fluctuates, making the future spot price unknowable; thus, making it difficult to control costs.
A forward contract would allow the farmer to enter into an agreement with the baker to sell his wheat at a specified price on a delivery date, thus giving both parties a certain price in the future.
A forward contract is an agreement to buy an asset on a specific date for a specified price. The forward contract is the simplest form of derivatives, which is a contract with a value that depends on the spot price of the underlying asset. The spot price of a commodity is the current market price, which fluctuates continuously according to supply and demand. The party that has the obligation to sell the underlying asset is said to be holding the short position while the party who has an obligation to buy the underlying asset is said to be long. Because forward contracts began with agricultural products and other commodities, the contract price is also known as the delivery price and the date on which the transaction will take place is often referred to as the delivery date, even when the forward contract is settled in cash.
Since the spot price of the underlying asset on the delivery date is unknowable, the contract price is set to the future value of the transaction, which depends on the present value of the transaction and the current interest rate. The contract price may also be modified by other factors, such as the cost of carry, which is the cost of holding the underlying asset during the term of the contract. Any other value for the contract would allow one party to profit through riskless arbitrage.
So, will contract prices actually equal spot prices at the time of settlement? Rarely. There is no reason to expect that contract prices will equal the actual spot prices on the settlement date, since spot prices depend on a multitude of factors that cannot be quantified at the time of the transaction, such as the supply and demand. Forward rates are used to determine settlement prices because, when interest rates are known, then the future value of the contract is also known, so that if future value, like present value, is not equal for both parties, then the parties would never agree to the contract. Nonetheless, because contract prices will rarely equal spot prices at settlement, one party will profit by the exact same amount that the other party loses.
Hedgers and Speculators
There are 2 basic types of parties to a forward contract. A hedger is one who enters into a forward contract to shed risk, while a speculator hopes to make a profit by taking on that risk.
As a hedge, a forward contract mitigates the risk for both parties, in that the seller can sell at a certain price and the buyer can buy at that same price. However, the spot price on the delivery date will almost certainly be different from the contract price. Therefore, as a zero-sum game, one party will suffer a loss and the other party will enjoy a gain equal and opposite to the other party's loss. However, if the forward contract was entered into as a hedge, then the loss or gain on the contract will be proportional to the gain or loss of the underlying asset. So if the farmer contracted to sell his wheat for $8 a bushel but the spot price on the delivery date was $7, then the farmer gains one dollar on the contract, which offsets the $1 loss per bushel on the wheat. Likewise for the baker: the loss of $1 on the contract is offset by the cheaper price of the wheat.
However, speculators have no interest in the underlying asset — they only hope to make a profit. Thus, one speculator's profit is another's loss.
The payoff for the long party is equal to the spot price minus the contract price, while the payoff for the short party is equal to the contract price minus the spot price:
Long Party Payoff = Spot Price – Contract Price
Short Party Payoff = Contract Price – Spot Price
That one party's gain is equal to the other party's loss can be seen more clearly by looking at the table for gold, where the contract price is set to $1400:
|Gold Spot Price||Short Return||Long Return|
The line illustrating the long party's profit or loss is equal and opposite to the short party's loss or profit. Only in the unlikely event, where the spot price is equal to the contract price on the delivery date will neither party gain nor lose.
A major risk of forward contracts is credit risk, where the counterparty, for one reason or another, fails to fulfill its obligation. To minimize credit risk, the transacting parties often post collateral to ensure performance.
Forwards Are Fundamental Derivatives
Forwards are the simplest type of derivatives; indeed, most derivatives can be viewed in terms of forward contracts. A futures contract is a forward contract that has been standardized and is traded on exchanges. Most parties do not take delivery of the underlying asset. Rather, they use futures to offset any losses in the spot price of the underlying commodity.
A swap derivative can be viewed as a portfolio of forwards. Even options can be considered a type of forward contract, in that the writer of an option that is exercised has an obligation to sell the underlying asset at the strike price. However, the long party of the transaction, the holder of the option, only has the right, but not the obligation, to buy the underlying asset.
Besides commodities, forwards are often written to lock in certain exchange rates involving different currencies (FX forwards) or to guarantee interest rates on loans or investments; such agreements are often called forward rate agreements (FRA).