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cash contract by which two parties agree to the exchange of an asset (for
example, foreign exchange) to be delivered by the seller to the buyer
at some specified future date.
Forward contracts are especially important in the foreign exchange markets because they allow individuals and firms to protect themselves against foreign exchange risk. Suppose a company is going to import electronic parts from a French manufacturer in three months time at a price fixed in terms of francs. If the company waits for three months to buy the francs that it knows it is going to need, it assumes foreign exchange risk: the dollar price of the franc may appreciate, raising the dollar price of the electronic parts. Instead of assuming the risk, the company may choose to purchase a forward contract today for the delivery of francs three months from now. Then even if the price of francs appreciates, the company has guaranteed that it will be able to purchase the electronic parts at a price in dollars that it is willing to pay.
In the foreign exchange market, the forward price and the spot price are linked by the interest parity condition. This condition says that the percentage difference between the forward rate (F) and the spot rate (S), called the forward premium, will equal the difference between the real (inflation adjusted) foreign interest rate (if) and the real domestic interest rate (id):
(F - S)
for example, the real foreign interest rate is 10 percent and the real
domestic rate is 8 percent, the interest parity condition implies that
the forward rate will be 2 percentage points higher than the spot rate.
This condition holds because rational investors who need foreign currency in the future always have the option of buying the currency now on the spot market and investing it in an interest-earning foreign bank account until needed or buying a forward contract for the future purchase and delivery of the foreign currency and investing the funds in an interest-earning domestic bank account until the foreign currency is delivered. The normal operations of efficient markets and rational investors insures that the expected cost of these two alternatives will always be equal; therefore, the difference between the spot rate and the forward rate reflects differences in real interest rates.
A forward contract is very similar to a futures contract, but there are two important differences. First, forward contracts are negotiated between two parties so that they may reflect individualized terms and conditions. In contrast, a futures contract is traded on an price, including size of the contract, delivery date, grade of commodity, etc. Second, forward contracts are not marked to market each day by an exchange as is the case with futures contracts. As a result, gains and losses on forward contracts are recognized only when the contract matures, while holders of future contracts must recognize the rise or fall in the value of their contracts as they are marked to market by the exchange.