A forward contract is an agreement between two individuals or businesses to purchase or sell goods for a fixed price at a future time. It sets a specific price for the asset and prevents market pricing volatility.
It is common for the price of commodities like oil to change unpredictably. In such instances, a forward contract can be helpful to lock in an agreed price during the initial stage of the transaction.
Forward contracts are a form of derivatives that are based on underlying assets delivered on a specific date. The one buying the contract becomes an investor and enters a long position. The party that sells the forward contract comes into a short position.
After the contract is signed, the buying party benefits from the increase in the price of the asset. However, if the price of the asset decreases, the seller has an advantage over the buyer.
How Do Forward Contracts Work?
Forward contracts are helpful for business owners to protect them against fluctuating market values for currencies and commodities. For example, the success of an oil refining company will depend on the market price of oil. If the price lowers, the company can sell its products for a cheaper rate and secure more profits. If the price of oil rises, the company is likely to raise prices and get fewer profits.
Since prices of commodities change frequently, it can be challenging for businesses to predict the prices in the future and make long-term product decisions. Forward contracts allow such businesses to secure the prices of their raw materials to avoid unpredictable changes. It gives business owners an exact estimation of the costs for the following months and allows them to manage their expenses accordingly.
For instance, if the current market price of oil is 60 AUD per barrel, an oil refining company may sign a contract with the oil supplier to purchase over 5000 barrels of oil every month at 65 AUD. If the market price of oil exceeds 65 AUD, the company are still only obliged to pay a fixed rate of 65 AUD for each oil barrel as per the forwarding contract. In the case the market price of oil rises to 70 AUD per barrel, the forwarding contract allows the company to save over 25,000 AUD each month.
However, if the market price drops or stays fixed, the company will not benefit because it is purchasing the raw material for more than the current market price. Although, the company may still benefit from knowing their exact expenses for the upcoming months in advance, and further enable them to better project future revenue.
Settlement of a Forward Contract
Forward contracts are based on centralized transactions. They are customized contracts created and settled between two individuals or companies. When a forward contract comes to an end, the settlement needs to be made according to the agreed terms.
These contracts are usually not traded on exchange markets and the terms of the contract are different for every business. This is why forward contracts are generally used by investment companies, including investment banks or hedge funds. Additionally, they are not as accessible to retail investors on an individual basis.
Forward contracts can be settled in two ways: cash or delivery basis. If the initial contract was made on delivery, the seller is obligated to transport the commodity or goods to the purchaser.
The purchaser will then pay the seller the price that was agreed in cash. If the preliminary contract was based on cash, the purchaser will have to pay on the decided date but the assets will not be transferred. The settlement amount is decided through the variance between the forward price and the current price.
Components of a Forward Contract
The forward contract usually outlines the quantity of the commodity or asset, time and date of the sale, terms of handling conflict, and contract termination details. Other considerations depend on the relationship between the parties and any further arrangements necessary for the execution of the contract.
The four integral components of a forward contract include the asset, the quantity of the asset, the expiration date, and the price.
Asset or commodity: The product that is mentioned in the forward contract for buying and selling.
Quantity of the asset: The particular amount of the asset in units being traded. The quantity determines the category of the forward contract.
Expiration date: It is essential to agree upon the expiry date of the contract. The contract will be settled, the underlying asset will be transferred by the seller and the payment will made by the buyer on the agreed date.
Price: The price of the contract will be decided by both parties at the start of the agreement. The same price will then be paid at the expiration or maturation date. The fixed price will not include any currency changes.
Why Do You Need A Forward Contract?
A forward contract serves many purposes to business owners. The most important benefit of securing a contract is to prevent potential losses in the business.
Fixing the price of the commodity can save disruption in the budget and help simplify the financial planning process. Industries that purchase huge quantities of raw materials usually experience volatility in market prices. The guaranteed price comes in use as it gives a clear idea of how much cost will be spent on production.
Moreover, the guaranteed availability of raw materials that are needed for the business to produce goods can further enhance production levels. When considering the oil industry, a forward contract can help set in place the exact quantity of barrels that will be available every month (until the expiry of the contract).
These contracts are beneficial in an economy where prices of commodities and currency exchange rates frequently change. Mass production is possible through a secure forward contract to make sufficient purchases for the near future.
Forward contracts may also be used for speculative reasons. A speculator can predict that the price of a commodity will increase after a certain time and purchase the asset. If their prediction is correct and the market price increases, then they will profit from the contract.
Hire a Professional
It is always safe to consult a legal expert before executing any contracts.
Our team at Lazarus Legal is highly skilled at dealing with commercial matters and can guide you through the process of establishing your business. Get in touch with us to know more about our services and discuss how we can help you with all your legal matters.
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Mark Lazarus, the visionary behind the business and the fresh blood of the Lazarus Legal team, Mark (or Laz as he is often known) owes much of his success to his past experiences. And he’s made it his personal goal to bring that wisdom and formula to the firm.