Forward contract
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A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. Therefore, the trade date and delivery date are separated. Beside other instruments, such as Options or Futures, it is used to control and hedge risk, for example currency exposure risk (e.g. forward contracts on USD or EUR) or commodity prices (e.g. forward contracts on oil). The forward price will usually give a good market estimation of the price in the future.
One party agrees to buy, the other to sell, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to an pre-agreed rule or schedule. Otherwise no asset of any kind actually changes hands, until the maturity of the contract.
The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually next business day). The difference between the spot and the forward price is the forward premium or forward discount.
Example: Suppose Andy owns a house that is valued at $100,000 and that Bob enters into a futures contract to buy the house one year from today. But since Andy knows that he can only get the $100,000 in a years time, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate ) for one year is 4%. So if Andy had sold the house now for $100,000 and put the money in the bank, he would get $104,000. So Andy would want at least $104,000 one year from now for the contract to be worthwhile for him. But Bob knows that the house would fetch $6,000 a year if it was rented out and that Andy has currently rented the property out. So Bob wants to be compensated for the rental income. So Bob would be willing to pay $104,000-$6,000=$98,000. This would be the forward price for the house today.
To generalise, if <math>S_{0}<math> is the Spot-Price of an asset, <math>D<math> is the dividends from the asset, and <math>C<math> is the Cost of maintaining the asset. The Future Price
F(t,T) = S(1+R) - D + C
This can also expressed as the Forward price, S is again the spot price of the asset, r is the risk-free force of interest and I is the present value of all dividens/coupons/rent/etc. (discounted using r).
F = (S - I)exp(rT)
See also
- Derivative securities
- Forward market
- Futures contract (a form of forward contract that has been standardised for a wide range of uses)
- Hedging
- Options
- Futures
- Swapsfr:forward