Forward contract

[1][2] The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

Since the final value (at maturity) of a forward position depends on the spot price which will then be prevailing, this contract can be viewed, from a purely financial point of view, as "a bet on the future spot price"[3] Suppose that Bob wants to buy a house a year from now.

At the same time, suppose that Alice currently owns a $100,000 house that she wishes to sell a year from now.

At the end of one year, suppose that the current market valuation of Alice's house is $110,000.

The similar situation works among currency forwards, in which one party opens a forward contract to buy or sell a currency (e.g. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time.

Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.

But since Alice knows that she can immediately sell for $100,000 and place the proceeds in the bank, she wants to be compensated for the delayed sale.

is the continuously compounded risk free rate of return, and T is the time to maturity.

The intuition behind this result is that given you want to own the asset at time T, there should be no difference in a perfect capital market between buying the asset today and holding it and buying the forward contract and taking delivery.

For investment assets which are commodities, such as gold and silver, storage costs must also be considered.

is the continuously compounded storage cost where it is proportional to the price of the commodity, and is hence a 'negative yield'.

However, it is important to note that the convenience yield is a non cash item, but rather reflects the market's expectations concerning future availability of the commodity.

If users have low inventories of the commodity, this implies a greater chance of shortage, which means a higher convenience yield.

There are a number of different hypotheses which try to explain the relationship between the current forward price,

[4][5] Thus, hedgers will collectively hold a net short position in the forward market.

The other side of these contracts are held by speculators, who must therefore hold a net long position.

Hedgers are interested in reducing risk, and thus will accept losing money on their forward contracts.

Likewise, contango implies that futures prices for a certain maturity are falling over time.

[7] Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures, that is the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open.

Therefore, forward contracts have a significant counterparty risk which is also the reason why they are not readily available to retail investors.

[8] However, being traded over the counter (OTC), forward contracts specification can be customized and may include mark-to-market and daily margin calls.

Having no upfront cashflows is one of the advantages of a forward contract compared to its futures counterpart.

Especially when the forward contract is denominated in a foreign currency, not having to post (or receive) daily settlements simplifies cashflow management.

[9] Compared to the futures markets it is very difficult to close out one's position, that is to rescind the forward contract.

For instance while being long in a forward contract, entering short into another forward contract might cancel out delivery obligations but adds to credit risk exposure as there are now three parties involved.

This means selling one unit of the asset, investing this money into a bank account and entering a long forward contract costing 0.

Note: if you look at the convenience yield page, you will see that if there are finite assets/inventory, the reverse cash and carry arbitrage is not always possible.

If these price relationships do not hold, there is an arbitrage opportunity for a riskless profit similar to that discussed above.

This is due to firms having Stackelberg incentives to anticipate their production through forward contracts.