A forward price refers to a price agreed upon by the seller and the buyer of an asset, such as a stock, commodity or currency, for a transaction that will take place at a set date in the future. The two parties in a forward contract privately negotiate the terms and sign the contract without going through an exchange. At the signing of a forward contract, no money changes hands.
In a forward contract, the seller should be compensated for holding the asset for the buyer instead of investing it or using it for some other more profitable purpose. The forward price, therefore, has to be at least the current price of the asset plus the interest it would accrue if it sits in a risk-free investment vehicle, such as a bank savings account or a term deposit. This standard is derived from the idea that for the buyer to buy the asset now at the current price with no initial outlay, the buyer has to take out a loan and pay interest on it.
The forward price also has to take into account the seller's carrying cost, which refers to the costs and benefits of keeping and storing the asset. In the case of commodities such as gold, the buyer has to compensate the seller for storage costs. Carrying cost also can be negative, which means that the seller benefits from keeping the asset. For example, the seller could gain interest from currency, earn dividends from stocks or be protected from shortages in the case of oil or other fuels.
Signing a forward contract means entering a zero-sum game, where the amount of money won or lost is always equal. For example, if the forward price is $50 US Dollars and the market price turns out to be $55 USD on the specified date, the seller has to provide the item for $50 USD. In this case, the seller loses $5 USD, which is the same amount of money that the buyer essentially wins.
Investors and speculators can use forward contracts to benefit from price fluctuations. Forward contracts also can help a person or a firm hedge risks that originate from price fluctuations. For example, a multinational company that worries about exchange rate fluctuations can use a forward contract to lock in an exchange rate and protect itself from unfavorable fluctuations. It will not benefit from favorable exchange rate fluctuations, but this should not be the focus of a company whose main business is not exchange rate speculation.
