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A forward contract is a customized agreement between two parties to buy or sell an asset at a specific price in the future.
A forward contract is a customized agreement between two parties to buy or sell an asset at a specific price in the future. Forward contracts can be used for hedging or speculation, although their non-standardized nature makes them particularly suitable for hedging.
Unlike standard futures contracts, forward contracts can be customized based on the commodity, quantity and delivery date. Commodities that can be traded include grains, precious metals, natural gas, oil and even poultry. Depending on the terms of the contract, forward contracts can be settled in cash or delivery.
Forward contracts are not traded on a centralized exchange and are therefore considered over-the-counter instruments. While its OTC nature facilitates customization of terms, the lack of a centralized clearing house also results in higher default risk.
Important Note: Due to their potential default risk and lack of a centralized clearing house, forward contracts are not as readily available as futures contracts and are less accessible to retail investors.
Forward and futures contracts both involve agreements to buy or sell a commodity at a fixed price in the future, but there are some subtle differences. Forward contracts are not traded on exchanges, whereas futures contracts are.
Forward contracts are settled at the end of the contract, while futures contracts are settled daily. Most importantly, futures contracts are standardized contracts and there is no customization between the parties. [1]
The market for forward contracts is huge because many of the world's largest corporations use it to hedge currency and interest rate risks. However, the size of the market is difficult to estimate because the details of forward contracts are limited to buyers and sellers and are not accessible to the public.
The sheer size and unregulated nature of the forward contracts market means that in the worst-case scenario, it could suffer a series of cascading defaults. Although banks and financial institutions reduce risks by carefully selecting counterparties, the possibility of large-scale defaults still exists.
Another risk stemming from the non-standardized nature of forward contracts is that they only settle on a settlement date, rather than on a regular mark-to-market basis like futures contracts. What should be done if there is a large gap between the forward interest rate stipulated in the contract and the spot interest rate at settlement?
In this case, the financial institution originating the forward contract faces higher risks than a contract that is settled regularly to mark-to-market, thereby increasing the risk in the event of a customer default or non-settlement.
[1] CME Group. "Futures Contracts Compared to Forwards."
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