What is a forward contract? Definition, pros and cons

Panna Kemenes

22.11.21 (updated more than 1 year ago)

5 minute read

Forward contracts fix the price paid for goods and services in the future.

They are common in trade deals to lock in prices and protect the company against future price changes. They can also be used to hedge against changes in currency exchange rates or interest rates.

Forward contracts are customizable and specific to the two parties involved.

📝 This article will cover:
What a forward contract is, and how it works Forward contract examples Forward contract types Pros and cons of forward contracts How to get the mid-market rate on international payments

This piece has been written in collaboration with Esther Friedberg Karp, an esteemed bookkeeper and QuickBooks ProAdvisor.

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What is a forward contract, and how does it work?

What is a forward contract?

A forward contract is a contract to buy or sell an asset in the future at an agreed price.¹

It is an agreement between two parties to trade the agreed-upon asset for the agreed-upon price on a specified date.

How does a forward contract work?

A forward contract can be specified between any parties for any asset.

In trading activity, they are often used to fix prices for goods or services to be supplied at a future date. This protects the purchaser from future price changes, helping them plan business cash flow.

Forward contracts can be used for international purchases. In these cases, such contracts can be used to hedge against exchange rate fluctuations.

Forward contract

What is a forward contract example?

There are plenty of forward contract examples. In trading, these usually involve situations where there is a possibility that prices could change in the future. Fixing them with a forward contract enables the customer to control this risk.

International trade is a common area for this.

Consider that a US-based small fashion company is buying textiles from a UK-based supplier. These textiles are critical to the business, and they place several future orders to ensure sufficient future supply.

If the business uses a forward contract, the price of the textile deliveries that have been ordered for a later date, e.g. six months from now, will be paid at a guaranteed price. If the forward contract is not used, the price of the textiles could increase, and the business may not have the funds to pay for the order when it arrives.

A forward contract will fix the price that the customer pays for its future order on a specific date. If the selling price of the textiles changes (in either direction), this will not affect the price to be paid.

In this example, there could also be changes in the exchange rate between the US Dollar and the British Pound. The forward contract can also extend to fix the exchange rate in order to avoid fluctuations.

As a forward contract is defined between the two parties, it could be specified in either currency.

Alternatively, a separate forward contract could be used to hedge against changes in the exchange rate.

For example, if your business is paying for goods in British Pounds, but the payment is only due in 3 months time, you could hedge the next payment with the help of a foreign exchange forward.

In this case, you need to be aware of the fees involved.

You could enter a foreign exchange forward contract with Western Union, for example. In this case, a payment of 10,000 GBP could incur a 0.50% credit charge, and 0.05% operating costs - adding up to 55GBP in total.

The credit charges can vary between 0.01% to 3.00% - which can become quite costly. These charges depend on several factors, including the rating of the company, and the tenor of the trade.²

Forward contract fees

Types of forward contracts

Not all forward contracts are the same. There are different types used – usually with different rules for the date or dates the contract can be settled.³

The following are some of the most common types of forward contract:

Closed outright. This is the standard type of forward contract. It specifies a fixed price for a specific date in the future.
Flexible. A flexible contract can be settled at any point up to and including the settlement date. The customer can do this using one or more payments. This can be useful, for example, in contracts with overseas suppliers. If specified in the foreign currency, payments could be made at any time the exchange rate is more favorable.
Long-dated. In these contracts, the settlement date is further in the future. A standard contract is usually forward dated up to one year. A long-dated contract could be up to 10 years.
Window forwards. A window forward contract specifies a range of settlement dates. This provides a period of time (such as one month) over which the contract can be settled. This can help to manage exchange rate risk.

Forward contracts are negotiated between two parties. There is flexibility over the definition and content, but they should always include:

The asset involved. This could include any traded goods or a currency.
Quantity. It is usual to fix the amount of the asset involved.
Price. The future price that will be paid. This should also include the currency.
Trading date. The end date of the contract, when payment is due for the asset. Some types of forward contract offer flexibility in this.

What is the difference between a future and a forward contract?

Futures and forwards are similar. They both involve an agreed price and order quantity for a specific future date. There are some key differences when comparing futures vs. forwards, though.

Forwards are more common between customers and suppliers. Forward contracts are private and customized contracts between two parties. They can only be settled on the date specified in the contract.
Futures, on the other hand, are standardized contracts that are usually tradable. They can typically be traded on an exchange and settled any time before expiration.

Forward contract types

Pros and cons of using a forward contract

Forward Contract Pros:

Guarantees a future price and allows the company to control supply and risk.
Can be used to hedge currency and interest rate risks.
Contracts are flexible and can be defined for a specific situation.
Can help in predicting cash flow
Can be useful to plan investments where companies can decide to lock in funds (in any currency) and earn income before the funds are due for the contract

Forward Contract Cons:

Of course, prices could move in either direction. The price or exchange rate could move against you, and you end up paying more than the standard price in the future.
A forward contract is more complicated than a standard contract.
With a longer timeframe, it carries an increased risk of non-payment or default.

Are there other ways to protect your money from currency risks? Insights from Esther at EFK Compubooks:
One method that a company can use to insulate itself from currency risk is to hold a balance in a foreign currency that will be required for a particular outlay in a few months. But that means not being able to touch that working capital for the period of time that currency needs to be “set aside.” Most companies don’t have the working capital to put in a bank account and sit there, accumulating bank fees. Also, it is not always possible to create a bank account denominated in most other currencies using a domestic bank. For currencies that are available, there are generally fees to keep the bank account open, as well as fees to move the funds around. And for currencies that are not available, it is difficult and expensive (if possible at all) to open a bank account in another country just to have an account in that currency. This is where a multicurrency account can help. Businesses can use a multicurrency account to hold various currencies - and often with lower fees than traditional banks. This can be a flexible and affordable solution for making overseas payments.

Are there other ways to protect your money from currency risks? Insights from Esther at EFK Compubooks:

One method that a company can use to insulate itself from currency risk is to hold a balance in a foreign currency that will be required for a particular outlay in a few months. But that means not being able to touch that working capital for the period of time that currency needs to be “set aside.”

Most companies don’t have the working capital to put in a bank account and sit there, accumulating bank fees.

Also, it is not always possible to create a bank account denominated in most other currencies using a domestic bank. For currencies that are available, there are generally fees to keep the bank account open, as well as fees to move the funds around.

And for currencies that are not available, it is difficult and expensive (if possible at all) to open a bank account in another country just to have an account in that currency.

This is where a multicurrency account can help. Businesses can use a multicurrency account to hold various currencies - and often with lower fees than traditional banks. This can be a flexible and affordable solution for making overseas payments.

Always get the mid-market rate on international payments with Wise

Forward contracts serve an important purpose. They are useful in international trade, as they can mitigate the risk of changing exchange rates.

But forward contracts can also be costly and complex.

Getting the best exchange rate for any transaction can make a big difference in the company's cash flow.

Wise Business can help with this. Wise offers a flexible and easy way to pay international suppliers. Fees are low and transparent, and the exchange rate used is always the real, mid-market rate.

Discover how Wise Business
can save you time and money

You can also move money between currencies when the exchange rate is optimal - all from the same account.

It is also possible to get local account details in up to ten major currencies. This means your US business can have UK account details, for example, to receive payments with ease.


	This piece has been written in collaboration with Esther Friedberg Karp, an esteemed bookkeeper, QuickBooks ProAdvisor, and founder of CompuBooks. Esther Friedberg Karp, MBA, is an internationally-renowned trainer, writer, business consultant, and speaker with advanced certifications in both QuickBooks Desktop and QuickBooks Online. She has been named twice to the list of Insightful Accountant’s Top 10 QuickBooks ProAdvisors worldwide, with the titles “Top International ProAdvisor” and “Top Trainer/Writer ProAdvisor.”

This piece has been written in collaboration with Esther Friedberg Karp, an esteemed bookkeeper, QuickBooks ProAdvisor, and founder of CompuBooks.

Esther Friedberg Karp, MBA, is an internationally-renowned trainer, writer, business consultant, and speaker with advanced certifications in both QuickBooks Desktop and QuickBooks Online.

She has been named twice to the list of Insightful Accountant’s Top 10 QuickBooks ProAdvisors worldwide, with the titles “Top International ProAdvisor” and “Top Trainer/Writer ProAdvisor.”

Sources:

All sources checked November 22, 2021.

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