From the course: Derivatives Fundamentals

Understanding forward contracts and their purpose

From the course: Derivatives Fundamentals

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Understanding forward contracts and their purpose

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- [Instructor] Our first category of derivative contracts are forward contracts. So what is a forward contract? Well, a forward contract is simply an agreement between two parties to exchange an asset for a pre-specified agreed price upfront, but on a specific date in the future. Here are a few examples. So for example, in one year's time, maybe party A agrees to purchase 8,000 barrels of oil from a party B at an agreed price now of $50 per barrel, or $40,000 in total. We've locked in a price for the oil now at $50 a barrel, but we won't deliver that oil for a year's time. It could be, for example, in one month's time, party A agrees to purchase 500,000 U.S. dollars from party B for 675,000 Canadian dollars. Again, we're locking in an exchange right now, but the delivery of the currencies will take place in the future. In this case, one month, or in five years time, party A agrees to purchase 600 troy ounces of gold from party B for 900,000 U.S. Again, the price is agreed now $900,000, but the delivery of the gold will be in the future, in this case, five years time. So what is the purpose of a forward contract? Well, as we've already said, forwards are over-the-counter, OTC contracts. Although they can be used for speculating, the customizability of forward contracts makes forwards very useful for hedging. For example, industries that are heavily reliant on commodities, such as an airline, for example, that relies on jet fuel, they can hedge the price of this jet fuel using forwards to reduce volatile prices and match exactly the amount of fuel they intend to buy over a period of months and years. When we talk about the components of a forward contract, there are five important components. One, the underlying asset, whether that be a commodity, a stock, an interest rate, or a currency, the expiration date, when will the commodity, for example, be delivered? The price that we're going to agree upfront, as we saw in our three examples. The quantity, and the neat thing about a forward contract is the quantity can be tailored to the two parties. Futures contracts have standardized quantities and standardized expiration dates, whereas an OTC forward contract can be tailored between the two parties to match the exact quantity that the two parties want to trade. And then fifth, there's the type of delivery, and we've talked about this already. Typically when we hear type of delivery, it's whether the derivative will be physically settled or cash settled.

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