Advantages and disadvantages of forward contracts

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Advantages and disadvantages of forward contracts
A forward contract is when two parties agree to buy or sell a product at a specific price (Hemera Technologies/AbleStock.com/Getty Images)

A forward contract is when two parties agree to buy or sell a product at a specific price, but the actual transaction will take place at a certain date in the future. A spot contract is when a product is bought or sold immediately. One characteristic of forward contracts is that the price on the day of making the agreement is the price at which the product is transacted at the later date. This is done regardless of whether the price increases or decreases.

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Protection against exchange rate fluctuations

Forward contracts can be beneficial in the agricultural industry, and farmers use them to protect against the risk of crop prices declining before harvesting can be done. For example, a farmer plants a crop of wheat and expects the crop to yield 10,000 bushels at harvest time. To protect themselves against the risk of the wheat price dropping, they will sell the entire 10,000 bushels that they expect to harvest to a buyer. The two parties make an agreement and fix the price of a bushel of wheat, delivery to be made five months from the date of the transaction agreement. Money does not change hands at this time. The farmer has protected himself/herself from possible exchange rate fluctuations and declines in the wheat market. Of course, he/she takes the risk that the price of wheat will not go up.

Hedging against risk

For many people, risk management is the primary motivation for forward contracts. Companies use forward contracts to hedge their risk against foreign exchange. For example, a company based in the U.S. incurs costs in dollars for labour and manufacturing. It sells to European clients who pay in euros. The company has a lead time of six months to supply the goods. In this case, the company is at risk from uncertain market fluctuation of exchange rates. The company uses a forward contract to sell the product six months later at today's exchange rate.

Default risk

In a forward contract, there is no immediate obligation. As time moves forward, the forward price for delivery on the original date of the contract may change. Forward contracts can acquire value and become a liability for one party and an asset for another. Because no money changes hands at the time of making the contract, the risk of default is even higher. The seller may not deliver the product at the agreed price or the buyer may not pay the agreed price.

Variations in the physical characteristics of the product

Forward contracts involve buying a product, sight unseen. For this reason, one of the biggest problems with forward contracts is that the physical characteristics of the product can vary. For example, a forward contract for wool cannot guarantee the quality of the wool at the time of delivery. Wool can be stronger one year than the next, because wool quality varies from season to season. Variations in the product alter the price of the product. But with a forward contract, the seller has to pay the price as long as the contract states quality reaches a minimum agreed-on level.

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