Page 251 - A Canuck's Guide to Financial Literacy 2020

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Purchasing a Forward Contract

One important thing to remember about forward contracts is that, they do not trade on a
centralized exchange but rather over-the-counter (OTC). Due to their over the counter
nature and lack of a centralized clearinghouse, these contracts are highly customizable.

The party who buys the forward contract enters a long position where they believe the price
of the underlying asset will increase. Alternatively, the party who sells the forward contract
enters a short position with the belief that the underlying asset will decrease in price.

Elements of Forward Contract

Forward contracts have four unique elements of consideration.

• Asset - A forward contract is based on an underlying asset that the two parties
agree to do business around. The underlying asset could be a financial instrument
such as locking in the price of a currency or a commodity such as a farmer agreed to
sell his wheat at a specific price.
• Expiration Date - One important element of the contract is the start and the expiry
date. At what date is the contracted deemed settled and if applicable where will the
delivery of goods happen?
• Quantity - Quantity refers to the number of units of the underlying asset agreed to in
the contract.
• Price - The most important consideration is price. It refers to the price that the
parties have agreed to that will be paid upon settlement/maturity date. Information
about the currency that the payment will be processed is included as well.

Example: Forward Contract

Jim is planning to grow 500 bushels of wheat this year with the harvest happening in 6
months. He believes that the price of wheat will fall in the next 6 months and is looking to
lock in the price now. He negotiates a forward contract today that will obligate him to sell
500 bushels of wheat to Dempster's Bread Company at the time of harvest.

Jim locks in the price of the wheat now and thus eliminated the risk of the falling wheat
prices. Upon maturity, Jim will have to deliver 500 bushels of wheat to Dempster's Bread
Company.

Forwards vs Futures

Investors should be aware that forward contracts are not the same as future contracts.
Although both investments allow you to buy or sell an asset a specific time at a given price,
it's important to note that forward contracts do not trade on a standardized exchange but
rather over the counter. The contracts are private agreements with terms agreed between
the corresponding parties.