Forward price translates to a predetermined delivery price for any type of underlying asset, commodity, or currency. It is agreed upon by both the buyer and seller as a part of the forward contract and will be paid at a future date, which is also pre-decided. During the beginning of a forward contract, the forward price makes the contract value zero. However, the price movement of the concerned asset will trigger the forward price to assume a positive or negative value.
Like futures contracts, forward contracts are also designed on the principle of buying or selling an asset at a decided price in the future. However, a futures contract is traded on a public exchange, unlike a forward contract. The settlement for a forward contract occurs at the contract’s end, whereas a futures contract is settled daily. Most notably, futures contracts come with standardised agreement terms, and forward contracts can be tailored to suit the needs of the counterparties.
In this article, we will take a closer look at forward pricing’s basics, calculation, advantages, and disadvantages.
Fundamentals of the forward price
A forward price is derived from the current spot price of an underlying security along with the carrying costs such as interest, forgone interest, storage or additional expenses like opportunity costs.
At its inception, the forward contract has no intrinsic value, but with time, it will rise or fall. When positions are offset in a forward contract, they result in a zero-sum game.
Let us understand how this works. For instance, an investor enters a long position in a pork belly contract, and another investor enters a short position. Any profits made from the long position automatically equal the losses that the second investor had to bear from the short position. By establishing the initial value of the contract to zero, both the investors start on an equal footing at the contract’s inception.
Forward contracts are not readily accessible to retail investors, and the market for them is usually difficult to estimate. This is primarily because the terms and conditions of such agreements are often kept private between the buyer and the seller and not divulged to the public. Because of the unregulated and clandestine nature of forward contracts, there is an increased probability of counterparty risk, which implies that one party may fail to meet its obligations.
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Forward price formula
The following is the formula to calculate the forward price:
F = S × e(r×t)
Here:
- F is the forward price of the contract
- S is the current spot price of the underlying asset
- e is the mathematical irrational constant
- r is the risk-free rate used for the forward contract’s period of existence
- t is the delivery date (in years)
Difference between forward price and spot price
A forward price refers to a predetermined future delivery price for an underlying financial asset, commodity, or currency that both parties mutually accept. Conversely, a spot price stands for the current market price of an asset.
Additional read: Asset financing
Rationale behind locking a forward price
Some investors may wish to lock in a forward price to hedge against market volatility. For example, a farmer may utilise a forward rice contract ahead of the harvest to protect his financial interests in case there is a drop in grain prices due to the possibility of a natural calamity, such as famine or flood.
You may opt for a forward contract when you want a customised agreement to hedge against particular risks. Such contracts are also preferred when parties are dealing with assets or commodities that are not standardised or seeking privacy. However, if you desire ease of access, liquidity, and regulatory surveillance, it would be more prudent to choose a futures contract, which enables you to manage your transactions in a standardised and transparent fashion.
While locking in forward prices allows you to hedge, it does come with inherited risks. The primary disadvantage of locking in a forward price is that the price of an asset may end up not shifting in your favour, leading to losses compared to selling at spot prices on the delivery of an asset. Similarly, there is an elevated risk of nonpayment in scenarios involving longer-dated forward price contracts.
Additional read: Asset turnover ratio
Closing thoughts
Referring to an asset’s future delivery price, the forward price is mutually consented to by the buyer and seller of the forward contract. Initially, such contracts have zero value until the market conditions fluctuate. The forward price is computed by adding the carrying costs to the spot price of the underlying asset. Typically, these prices are used by investors to hedge against any unfavourable market movements. However, they can prove to be equally risky if the value of the asset shifts disadvantageously.
