In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument. The price agreed upon is called the delivery price , which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes.
Forwards, like other derivative securities, can be used to hedge risk typically currency or exchange rate risk , as a means of speculation , or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive. A closely related contract is a futures contract ; they differ in certain respects.
Forward contracts are very similar to futures contracts, except they are not exchange-traded, or defined on standardized assets. However, being traded over the counter OTC , forward contracts specification can be customized and may include mark-to-market and daily margin calls. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain. Since the final value at maturity of a forward position depends on the spot price which will then be prevailing, this contract can be viewed, from a purely financial point of view, as "a bet on the future spot price" .
Suppose that Bob wants to buy a house a year from now. Both parties could enter into a forward contract with each other. Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract. Bob has made the difference in profit. The similar situation works among currency forwards, in which one party opens a forward contract to buy or sell a currency ex. As the exchange rate between U.
Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.
In a currency forward, the notional amounts of currencies are specified ex: While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts. For liquid assets "tradeables" , spot—forward parity provides the link between the spot market and the forward market.
It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry , this effect can be broken down into different components, specifically whether the asset:. The intuition behind this result is that given you want to own the asset at time T , there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery.
Thus, both approaches must cost the same in present value terms. For an arbitrage proof of why this is the case, see Rational pricing below. The intuition is that when an asset pays income, there is a benefit to holding the asset rather than the forward because you get to receive this income. An example of an asset which pays discrete income might be a stock , and an example of an asset which pays a continuous yield might be a foreign currency or a stock index.
For investment assets which are commodities , such as gold and silver , storage costs must also be considered. Storage costs can be treated as 'negative income', and like income can be discrete or continuous. Hence with storage costs, the relationship becomes:. The intuition here is that because storage costs make the final price higher, we have to add them to the spot price. Consumption assets are typically raw material commodities which are used as a source of energy or in a production process, for example crude oil or iron ore.
Users of these consumption commodities may feel that there is a benefit from physically holding the asset in inventory as opposed to holding a forward on the asset. These benefits include the ability to "profit from" hedge against temporary shortages and the ability to keep a production process running,  and are referred to as the convenience yield.
Thus, for consumption assets, the spot-forward relationship is:. Since the convenience yield provides a benefit to the holder of the asset but not the holder of the forward, it can be modelled as a type of 'dividend yield'.
However, it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations concerning future availability of the commodity. If users have low inventories of the commodity, this implies a greater chance of shortage, which means a higher convenience yield. The opposite is true when high inventories exist. The relationship between the spot and forward price of an asset reflects the net cost of holding or carrying that asset relative to holding the forward.
The market's opinion about what the spot price of an asset will be in the future is the expected future spot price. The economists John Maynard Keynes and John Hicks argued that in general, the natural hedgers of a commodity are those who wish to sell the commodity at a future point in time.
The other side of these contracts are held by speculators, who must therefore hold a net long position. Hedgers are interested in reducing risk, and thus will accept losing money on their forward contracts. Speculators on the other hand, are interested in making a profit, and will hence only enter the contracts if they expect to make money.
Thus, if speculators are holding a net long position, it must be the case that the expected future spot price is greater than the forward price. Likewise, contango implies that futures prices for a certain maturity are falling over time. Specifically, and mirroring the trades 1. The sum of the inflows in 1. This is an arbitrage profit. Consequently, and assuming that the non-arbitrage condition holds, we have a contradiction. This is called a cash and carry arbitrage because you "carry" the asset until maturity.
Then an investor can do the reverse of what he has done above in case 1. It would depend on the elasticity of demand for forward contracts and such like. The forward price is then given by the formula:. The cash flows can be in the form of dividends from the asset, or costs of maintaining the asset.
If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed above. One implication of this is that the presence of a forward market will force spot prices to reflect current expectations of future prices.
As a result, the forward price for nonperishable commodities, securities or currency is no more a predictor of future price than the spot price is - the relationship between forward and spot prices is driven by interest rates.
For perishable commodities, arbitrage does not have this. For more details about pricing, see forward price. Allaz and Vila suggest that there is also a strategic reason in an imperfect competitive environment for the existence of forward trading, that is, forward trading can be used even in a world without uncertainty. This is due to firms having Stackelberg incentives to anticipate their production through forward contracts. From Wikipedia, the free encyclopedia.
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July Learn how and when to remove this template message. Derivatives Credit derivative Futures exchange Hybrid security. Foreign exchange Currency Exchange rate. Cost of carry and convenience yield. Normal backwardation and Contango. Keynes, A Treatise on Money , London: Hicks, Value and Capital , Oxford: Normal Backwardation , Investopedia. Energy derivative Freight derivative Inflation derivative Property derivative Weather derivative.
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