In a forward transaction, two people or other entities engage in a binding agreement to perform a trade in the future, rather than at the present. This difference in the timing of trades sets futures trades apart from spot trades. The assets being traded in the forward transaction make up its underlying assets.
Forward transactions provide a means of protecting investments against possible rate fluctuations. They are primarily used for speculative purposes. The buyer in a forward transaction speculates on a rise in the value of the underlying assets. The seller, on the contrary, speculates on a drop in the price of the underlying assets.
In theory, goods of all kinds can make up the underlying assets for futures transactions, including stocks, commodities or more general wares. A difference is made between conditional and unconditional forward transactions.
Where a conditional forward transaction – such as an options transaction – is used, the buyer can choose the timing of the transaction. The buyer can then either carry out the trade at the specified time, or forfeit the trade. While the seller is obliged to perform the trade, this obligation does not apply to the buyer.
In an unconditional forward transaction, both the buyer and the seller are obligated to fulfil the forward transaction agreement. Futures and swaps are examples of unconditional forward transactions traded on the stock market. Forwards are over-the-counter forward transactions.
Example of an unconditional forward transaction: A cocoa farmer hopes to sell his stock of cocoa beans at the highest possible profit. A chocolate producer in Switzerland wants to buy the cocoa beans at the lowest possible cost. On January 1, the farmer and the chocolate factory agree to a purchase volume of 100 kilograms of cocoa beans at a price of 25 francs per 10 kilos. They both agree that delivery and payment will occur on February 15.
Thanks to the forward deal, the farmer has the security of knowing that they have a guaranteed sale of cocoa beans worth 250 francs. The chocolate producer has the security of knowing that the cocoa will be delivered at the agree-upon price exactly 6 weeks after they sign the deal. Any fluctuations in cocoa prices which occur after the agreement is signed are no longer relevant for either party.
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