Forward contracts are non-standardised agreements between two parties, concerning the future delivery of a commodity for a presently set price. Commodity forward contracts are customisable. They are not traded through centralised exchanges and are therefore considered to be OTC (over the counter) instruments.
The utility of commodity forward contracts resides in the hedging possibilities they offer. Farmers can for instance sell their crops before the seeds go into the ground. Locking in a price ahead of time may not always turn out to be profitable for both parties.
While such contracts are difficult to break and legally binding, the situation they give rise to often incentivises one of the parties to default.
As mentioned, commodity forwards are customisable private contracts. Their customisable variables are: commodity type, delivery date and amount. Commodity forwards can be settled in cash or through actual delivery of the contracted commodity.
Commodity Forward Contract Example
A farmer plans to produce some 1 million bushels of corn. Before he even plants the crops, he strikes up a forward contract with a bank. Afraid that the price of corn may tank, and thus he may end up with a loss, the farmer agrees to a price of $4/bushel, to be delivered in 6 months.
Given that the counterparty to the farmer is a bank, this contract will probably be a cash-settled one. The same contract may exist between the farmer and a corn ethanol company too. In this case, it would likely involve physical delivery of the commodity.
In 6 months, three scenarios may unfold:
- – the price of corn is exactly at the $4 mark. In this case, the contract is effectively voided. No cash changes hands in the case of a cash-settled contract. The farmer simply delivers the corn as agreed, at $4/bushel, in the case of a physical delivery deal.
- – the price of corn has climbed to $5/bushel. In this case, the farmer owes the bank $1 million – the difference between the actual price and the contract-stipulated one. In case of physical delivery, the farmer is compelled to deliver the 1 million bushels at $4/bushel, taking a $1 million loss. He might default on the deal, in which case the ethanol company will likely sue him.
- – the price has dropped to $3/bushel. The bank owes the farmer $1 million. The ethanol company is obligated to purchase the agreed 1 million bushels at $4/bushel. If it decides to default on the deal, the farmer will sue it.
The Difference Between Commodity Forwards And Futures
Unlike futures, commodity forwards can be customised. Also, as mentioned, they are not standardised. Furthermore, futures trade at centralised exchanges, while forwards do not.
Futures contracts are settled on a daily basis, while the parties only settle forwards upon expiry.
From the OTC/custom nature of forward contracts stem some very specific risks.
The forwards contract market is an entirely private and unregulated one. Its size is estimated to be massive however. Scores of major financial institutions use this instrument to hedge their positions.
The most obvious risk carried by forwards contracts is that of default. The forwards market is nothing more than a series of independently negotiated bi-lateral agreements between various parties. Thus, the possibility of cascading defaults is very real.
Bigger players have certain solutions to mitigating this risk. Overall however, the possibility of default still looms.
The unregulated nature of the whole forwards environment presents yet another problem. Spot prices at settlement may differ widely from the price agreed in the contract. By this metric alone, commodity forwards can be considered very risky OTC hedging instruments.