Forward Price
Forward price is the predetermined delivery price for an underlying commodity, currency, or financial asset as decided by the buyer and the seller of the forward contract, to be paid at a predetermined date in the future. At the inception of a forward contract, the forward price makes the value of the contract zero, but changes in the price of the underlying will cause the forward price to take on a positive or negative value.
Forward Price
Definition
The forward price is the agreed-upon price between a buyer and a seller for a specific underlying commodity, currency, or financial asset, to be paid on a predetermined future date. At the inception of the forward contract, the forward price makes the contract's value zero, but changes in the underlying asset's price can cause the forward price to become positive or negative.
Origin
The history of forward contracts can be traced back to ancient agricultural societies, where farmers and merchants would agree on prices in advance to lock in future commodity prices and reduce the risk of price fluctuations. The modern form of forward contracts developed in the 20th century, particularly gaining widespread use in financial markets.
Categories and Characteristics
Forward prices can be categorized based on the underlying asset into commodity forward prices, currency forward prices, and financial asset forward prices. Commodity forward prices are typically used for physical goods like agricultural products and metals; currency forward prices are used in the foreign exchange market; financial asset forward prices involve stocks, bonds, and other financial instruments. Key characteristics of forward contracts include non-standardization, over-the-counter (OTC) trading, and counterparty credit risk.
Specific Cases
Case 1: Suppose a U.S. company expects to pay €1 million in six months. To hedge against exchange rate fluctuations, the company enters into a forward contract with a bank, agreeing to pay at an exchange rate of 1.2 USD per EUR in six months. This means that regardless of the actual exchange rate in six months, the company can make the payment at the agreed rate.
Case 2: A farmer expects to harvest 100 tons of wheat in three months. To lock in the price, he enters into a forward contract with a grain company, agreeing to sell the wheat at $200 per ton in three months. This ensures that the farmer will receive a stable income regardless of market price fluctuations.
Common Questions
1. What is the difference between forward price and futures price?
The forward price is non-standardized and typically traded OTC, while the futures price is standardized and traded on exchanges.
2. What are the main risks of forward contracts?
The main risks include credit risk and market risk. Credit risk refers to the possibility of counterparty default, while market risk involves the risk of price fluctuations in the underlying asset.
