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Forward Contracts Meaning & Definition

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Definition of Forward Contracts

Forward contracts represent the first advancement in commodities trading. Forward contracts are privately negotiated contracts for the purchase and sale of a commodity or financial instrument. The first forward contracts were developed for agricultural commodities like wheat and corn. The establishment of forward contracts allowed the buyer and seller of commodities to lock in prices for a delivery date in the future. The forward contract gave both parties the ability to manage Their businesses more efficiently. Farmers could now grow crops knowing that they had locked in a sale price for the crop. The forward contract also allowed the farmer to sell their crop without having to haul it to market, hoping there were buyers waiting with cash in hand. The buyer or users of the commodities through the use of a forward contract now knew that they had locked in the supply of the commodity to meet their demand at a set price. The price locked in or set under the forward contract could be the spot price on the date of delivery or a pre-negotiated price established between the two parties.

Applying "Forward Contracts" to Securities Exams:

While the forwards were an advancement over cash market transactions, forward contracts have significant drawbacks. Because the terms and conditions for each forward contract are negotiated on an individual basis, it is extremely difficult to find another party to take over the obligation under the contract should circumstances change between the contract date and the delivery date. There is no secondary market for forward contracts. Another drawback to the forward contract is counterparty or performance risk. The individual counterparty risk is borne by both parties to the forward contract. For the seller or producer of the commodity it is the risk that the buyer will not be able to make payment or take delivery. For the buyer of the commodity the counterparty risk is that the farmer may not be able to produce or deliver the commodity. It is important to master the terms and conditions relating to forwards to pass your series 3 exam. You are likely to see a number of questions relating to the risks to each party. Be sure you are ready to pass your series 3 exam with our greenlight pass guarantee

While forward contracts are heavily tested on NFA and CFTC exams we are hearing questions realting to forwards appearing on the series 65 and series 66 exam.

Good Luck on Your Exam !

The Securities Institute of America, Inc.

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