A forward contract is an agreement in which one party commits to buy a currency, obtain a loan or purchase a commodity in future at a price determined today. Exchange rate forward contract, interest rate forward contract (also called forward rate agreement) and commodity forward contracts are the three main types of forward contracts.
Forward contracts are derivative instruments mainly used by companies to hedge their risks. However, they can also be used to speculate on currencies, commodities, stock exchange, bonds, interest rates, etc. The party that agrees to buy the commodity, obtain a loan or purchase a currency, etc. is said to have a long position while the other party is said to have a short position.
A forward contract differs from the future contract in that the future contracts are standardized forward contracts traded on established futures exchanges while the forward contracts are over-the-counter instruments tailor-made to the exact requirements of the counterparties i.e. the parties which engage in the forward contract.
At the expiration of the forward contract, that profit that agrees to the party with short position i.e. the party that has bought the commodity or currency forward can be calculated as the difference between the spot rate on expiration and the agreed future rate at time 0. The following formula can be used:
$$ Profit\ to\ long\ position=(S_t-F_0)\times Q $$
Where St is the spot rate at time t i.e. the expiration rate, F0 is the forward rate agreed at inception of the contract i.e. time 0 and Q is the quantity of commodity or currency, etc.
A forward contract is a zero-sum game. Any profit (loss) that accrues to the long position is the loss (profit) of the short position.
It is 1 March 2017 and you work in an airline’s risk management department. Your company needs 2 million gallons of fuel by end of April. The spot rate is $2 per gallon and you expect the price to increase to $2.3 during the spring seasons due to higher seasonal demand. You can negotiate a forward contract with an oil marketing for delivery of 2 million gallons on 30 April 2017 at $2.1 per gallon. By entering into the contract, you commit to the trade if the fuel prices do not increase as you expect or even if they decrease.
On 30 April 2017, you can close the contract by buying the fuel from the oil marketing company requiring physical delivery or you can just settle it by paying (receiving) the difference between the new stop rate and the agreed rate.
Let’s say that actual price of the fuel is $2.3 per gallon on 30 April 2017, you can purchase pay $4.2 million to the oil marketing company and obtain delivery of 2 million gallons of fuel. Alternatively, you can buy the fuel from any other vendor for an amount of $4.6 million and receive $0.4 in cash from the oil marketing company. The amount that you receive is your gain on the forward contract:
$$ Profit\ to\ long\ position=($2.3-$2.1)\times2\ million=$0.4\ million $$
Your net cost is still $4.2 million i.e. $4.6 million paid to purchase fuel in spot market minus the profit on your forward position.
In a parallel universe, the OPEC countries increase their oil production drastically plummeting the fuel price to $1.8 per gallon by 30 April 2017. You still need to pay the oil marketing company an amount of $4.2 million for physical delivery. Alternatively, you can buy the fuel in spot market for $3.6 million (=$1.8 × 2 million) but you must pay the loss that you incurred on the forward position to the oil marketing company. Your loss amounts to $0.6 million and your net/total cost of fuel is $4.2 million i.e. price paid in spot market of $3.6 million plus the loss incurred of $0.6 million.
You can see that you have locked a price of $2.1. Your total payoff is $4.2 million no matter what happens to the spot market by the expiration time. However, forward contracts expose you to counterparty risk, the risk that oil marketing company mightn’t be able to honor its obligation. It is better to engage in future contracts which differ from forward contracts in two ways: (a) they are traded on an exchange which guarantees payment and the risk of default is very low and (b) your profit or loss on the contract is recalculated frequently and adjusted in cash right away.