Forwards
A forward is a private agreement to buy or sell something at a set price on a future date. Here is how forwards work, why businesses use them and the counterparty risk that comes with a handshake deal.
What a derivative is
A derivative is a contract whose value comes from something else, called the underlying: a stock, an index, a commodity, a currency or an interest rate. The main types are forwards, futures, options and swaps. Derivatives let people hedge risks, speculate or lock in prices.
The forward contract
A forward is the simplest derivative: two parties agree today on a price for a trade that happens later. A coffee roaster might agree to buy 10,000 pounds of beans from a grower in six months at $3.50 a pound, a hypothetical price. Whatever the market price is then, they trade at $3.50.
Who wins and who loses
| Coffee price in six months | Roaster (buyer) | Grower (seller) |
|---|---|---|
| $2.50 | Pays $1.00 more than market | Gets $1.00 more than market |
| $3.50 | Even | Even |
| $4.50 | Saves $1.00 a pound | Misses $1.00 a pound |
Hypothetical $3.50-a-pound forward. Both sides gained certainty, whatever the outcome.
Forward features and risks
- Customized: any amount, date or quality the two sides agree on.
- Private: traded directly or through a bank, not on an exchange.
- Counterparty risk: if the losing side cannot or will not pay, the other side may be stuck.
- Hard to exit early without the other party’s agreement.
Key takeaways
- Derivatives get their value from an underlying asset.
- A forward locks in a price for a future trade.
- Forwards are customized and private.
- Counterparty risk is the main danger.