From Traderpedia

An agreement between two parties to exchange assets at a specific time in the future.

An example would be a contract in which a buyer agrees to purchase gold from a seller at $400/oz three month hence. Some forwards are standardized in to futures and traded on exchanges. The remainder are traded over-the-counter.


[edit] Use of Forwards

Forwards are generally used for hedging purposes.

[edit] Forward Markets

Because of the popularity of the futures market, forwards are not, perhaps, as prevelent in commodities as they once were. There remains, however, good volume in both fixed income and foreign exchange.

[edit] Pricing Forwards

Forwards prices are linked with those of their underlying market. They do not, however, trade in lock step with the spot market. Because forward contracts by definition deal with future activities, they include a time related element which varies by market. This creates a spread between the spot price and the forward price.

[edit] Carry

Carry is the cost (or benefit) which the holder of an asset incurs between the time the forward agreement is made until the time of delivery, as well as the cost for delivery of that asset to the buyer. For example, one holding gold could have a storage cost, plus shipping. Other sources of carry include:

[edit] Other influences

Other factors can come in to play in the spread. They are things which are thought to likely have an impact on the future price of the underlying. An example of this is in a fixed income forward. If the market believes the Federal Reserve will hike interest rates in the future, forwards prices for further out months will be affected beyond the point where the interest rate move is likely to occur.

Among the other potential influencers are:

  • Weather forecasts
  • Crop expectations
  • Government legislation

[edit] Convergence

As a forward contract nears its expiration/delivery date, the spread between its price and the spot market price will narrow. This is referred to as convergence. It reflects both a decrease in the carry and a more certain set of expectations in terms of other influences.