Guide to Forward Contracts

What is a Forward Contract?

A forward contract is an agreement to make a trade in the future, with the cost of that transaction being agreed beforehand. Forward contracts are made between two parties without the need for another organisation (such as an exchange or clearing house) to act as an intermediary. 

The absence of an intermediary makes a forward contract an over-the-counter (OTC) instrument, which is customisable so that both parties agreeing the trade are happy with the terms. Most commonly used for trading commodities, forward contracts are also a popular mechanism with which to exchange currencies.

In a forward contract, the party that agrees to buy the asset takes the position – called the long position – that the asset’s market value will have risen by the settlement date. And the party that agrees to sell the asset takes the position – called the short position – that it will have fallen. 

There are four constituent parts to a Forwards Contract:

Pros and Cons of Forward Contracts

A forward contract eliminates uncertainty by locking in the price of exchange in advance. While eliminating the risk of loss should the exchange rate move in an unfavourable direction, this protection also eliminates the possibility of gain should it move the other way.

Here is a breakdown of the pros and the cons of trading using forward contracts:

Is there a difference between a forward contract and a forward exchange contract?

A forward exchange contract is the term used to describe a forward contract for a currency exchange, so there’s no real difference between the two but ‘forward exchange contract’ is more specific to money transfers.

A forward exchange contract is a forward contract by which an individual or business commits to buying a specific amount of foreign currency at an agreed date in the future, with the exchange rate applied to the transaction agreed in advance. The rate of the exchange is set at the time that the contract is entered into, and the currency pair being traded constitutes the contract’s underlying asset.

The business or individual buying the currency will benefit if its value rises by the settlement date. The party that agrees to sell the currency will benefit if it were to fall.

Looking again at the general makeup of a forward contract, we can see that a forward exchange contract’s four components are:

When should I use a forward contract for transferring between currencies?

There are a variety of situations in which forward contracts can be helpful, as it can be useful to know exactly how much something will cost in advance – particularly when working to a tight budget. Here are some situations in which you might want to consider a forward contract:

How do forward exchange contracts work?

Taking a look at a forward exchange contract, we can see how forward contracts can be used to fix the price and settlement date of a currency exchange in advance. This example will guide you through how it works.

Example: buying a home abroad

Suppose you intend to purchase property abroad. You have chosen a town in Italy, and your agent in the region tells you that it can take up to eight weeks to complete a transaction.

At the current exchange rate, your budget is just enough to cover the average price of a property in your chosen area. You believe, however, that over the coming months ongoing economic events will cause the Euro to strengthen against the Pound. If this were to happen, your budget will effectively decrease before you’ve had the opportunity to complete a purchase and you might be priced out of buying the property.

To protect your budget, you can take out a forward contract and lock in the current rate of exchange for the British Pound to Euro pairing. This ensures that the money you have available is not at risk of decreasing over time due to changes in the rate while you search for a property that you wish to buy.

There is the possibility that the exchange rate could move in the opposite direction after you have agreed your forward contract. If this were to happen, you’ll still be locked into paying the exchange rate you previously agreed and you would end up spending more money than you would have needed to. A forward contract will always run this risk, but it allows you to be certain that you can make your purchase regardless of market movements.

Where can I take out a forward exchange contract?

In recent years, international payment specialists have sprung up on the internet and are now able to offer all the services that previously could only be accessed with banking institutions – including forward contracts. Banks still offer the ability to take out forward exchange contracts, but these money transfer companies serve as foreign exchange brokers and are less expensive than traditional banks, while being just as reliable. Their exchange rates are often better and their transfer fees lower, with some offering transfers for free.

Not all online money transfer providers will offer forward contracts, but a wide variety are able to offer these among their services. If finding a forward exchange contract is vital to your money transfer plans, then by shopping around you will easily be able to find this option.

Can forward contracts be used for any currency exchange?

Whether or not a currency exchange is possible depends on the sending and disbursing network of the money transfer company. A forward exchange contract is possible if a money transfer company supports the currency pairing for that exchange. With the variety of money transfer providers around, you can usually find forward contracts offered for any currency pairing, but you might have to spend some time searching if you’re exchanging between two lesser-used currencies.

What is hedging with forward contracts?

When entering into a forward contract, the parties agree a price for an exchange that will be unaffected by market movements. As we have mentioned, you can use forward contracts to profit off speculating about market movements, but they can also be used for a process known as hedging – which is what was happening in the example further up this page about the house purchase.

When hedging, a person or business aims to mitigate risk of loss by locking in the price for future trades. This allows them to plan ahead, free of the uncertainty of market fluctuations in the price of the asset that they intend to buy or sell. 

Take another look at the home purchasing example given earlier. In this instance, in order to manage the risk of having less money to spend on a property, the house-buyer committed to purchasing Euros at a future date for the current rate of exchange. By locking in a rate in advance of a transaction, the prospective house-buyer mitigated risk of loss by hedging against any changes in the market value of the assets they were purchasing.

What’s the difference between a Forward Contract and Futures Contract?

A futures contract is similar to a forward contract in that it is also an agreement between two parties to exchange an asset for a specific price at a future date. Unlike a forward contract, however, it is standardised and terms cannot be changed to suit any particular position that two counterparties might wish to take.

Here are the key differences between a Futures Contract and a Forward Contract:

Can I cancel a forward exchange contract?

Money Transfer companies allow a transaction to be cancelled if it has not yet been completed. 

While most companies (such as Paysend) require you to contact a customer support team by phone or email to request cancellation, others (such as Currency Fair) allow you to do so within your account with them. 

Forward contracts are usually quite straightforward to cancel before the date for which the transfer is set, but doing so is likely to incur some fees.

Summary

A Forwards Contract is an agreement to exchange some amount of an asset at a future, pre-specified date. It is an over-the-counter financial instrument that can be customised to suit the position which each respective party wishes to take. Used for hedging purposes, forward contracts provide certainty against changes in value over time and mitigates the risk of loss.

A forward exchange is a forward contract obliging participants to trade two designated currencies on a specified date in the future. The currency pairing is the underlying asset, and it is often used as a mutual hedge against fluctuations in the rate of exchange for those currencies over time.

Unlike futures contracts, forward contracts are not traded on an exchange, and can be customised by asset type and quantity, price and date of settlement. This means that futures contracts are more accessible over-the-counter financial instruments open to a wider range of people than those simply looking to profit from fluctuations in the value of assets.

If you’re looking to arrange a forward contract, then your best option is to compare between the various money transfer companies that are able to provide them. Simply fill in our comparison tool and we’ll show you your best options in a matter of seconds.