In finance, a forward contract (often referred to simply as a forward) is a non-standardize contract between two parties to carry out a specified transaction on a future date. The transaction will consist of one of the counterparts purchasing a specific asset from the other counterpart, for a predetermined price. This predetermined price is called delivery price and is equal to the forward price at the time when the contract is entered into by the two counterparts.
A forward contract is a type of derivative.
The party obligated to buy the underlying asset in the future assumes a long position, while the party obligated to sell the underlying asset in the future assumes a short position.
Why use a forward?
Forwards are chiefly used for speculation or hedging. Since they are non-standardized contracts, they are especially suitable for hedging and are commonly used for hedging currency risk and interest rate risk.
The forward market
Forwards are traded over-the-counter and the details of each individual forward tend to be kept privately by the participants. It is therefore difficult to estimate the size of the global forward market or make any detailed assumptions regarding it.
Forward or Futures?
Forwards and futures can look very similar, but there are differences.
- Futures contracts are exchange-traded, while forwards are over-the-counter traded. The lack of a centralized clearinghouse will typically entail a higher default risk for forwards. When banks and financial corporations use forwards to mitigate risk, they tend to be very picky in their choice of counterpart.
- Futures will typically have interim partial settlements or true-ups in margin requirements, while forwards typically wont (although there are exceptions).
- Unlike standard futures contracts, forwards are tailor-made. They can for instance be customized to any commodity, amount and delivery date. Settlement can occur on a cash or delivery basis.
A non-deliverable forward (NDF) is an outright forward or futures contract where no asset can be delivered. Instead, the counterparties will settle the difference in cash or similar. A majority of all NDF:s are short-term currency forwards that are cash-settled in United States dollars.
NDF:s are used is several different markets, including commodity markets and forex markets. They are especially popular in jurisdictions where forward FX trading is illegal. Trading in NDF:s took off in the 1990s, with a focus on emerging markets with capital controls and banns on taking national currency out of the country. NDF:s are traded over-the-counter (OTC).
Examples of currencies with NDF markets:
- Chinese Renminbi (CNY)
- Taiwan Dollar (TWD)
- Indian Rupee (INR)
- South Korean Won (KRW)
- Israeli Shekel (ILS)
- South African Rand (ZAR)
- Brazilian Real (BRL)