Forward Price

Published Apr 29, 2024

Definition of Forward Price

A forward price is the agreed upon price of an asset in a forward contract, which is to be paid and received at a specific future date. Forward contracts are a type of derivative financial instrument that obligate the buyer to purchase, and the seller to sell, an asset at a predetermined future date and price. The asset could be commodities, currencies, financial instruments, or other financial assets. The forward price is determined at the contract’s inception, reflecting both parties’ expectations of the asset’s future spot price.

Example

To illustrate, consider a farmer who is planting wheat and expects to have 1000 bushels ready for harvest in six months. Worried about potential price drops, the farmer enters into a forward contract with a bakery, agreeing to sell the wheat at a forward price of $5 per bushel in six months. This agreement allows the farmer to hedge against the risk of falling wheat prices. On the other hand, the bakery locks in the cost of wheat, protecting itself from future price increases. In this case, the forward price of $5 per bushel is set based on the current market expectations of wheat prices in six months, accounting for factors like expected supply and demand, storage costs, and the risk-free interest rate.

Why Forward Price Matters

Forward prices are a critical component of the financial markets, providing a mechanism for price discovery and risk management. By locking in prices today for transactions that will occur in the future, both buyers and sellers can manage price volatility and budget with more certainty. For businesses, this can mean more stable input costs and selling prices, leading to more predictable cash flows. For investors, forward contracts can be a means to speculate on future price movements without needing to hold the physical asset. Furthermore, understanding forward prices is essential for those involved in the valuation of derivatives, investment analysis, and risk management strategies.

Frequently Asked Questions (FAQ)

How is the forward price determined?

The forward price of an asset is determined by the spot price (current price), plus or minus the cost of carry during the period until the forward contract expires. The cost of carry includes storage costs, interest costs if the asset is financed, and less any income the asset may generate, such as dividends or coupons. In theory, forward prices should align with market participants’ expectations of the future price of the asset, adjusted for the costs and benefits of holding the asset until the contract’s expiry.

What is the difference between forward price and spot price?

The forward price is the agreed-upon price for an asset in a forward contract to be paid and received in the future, while the spot price is the current market price at which an asset can be bought or sold for immediate delivery. While the spot price reflects current supply and demand conditions, the forward price reflects the market’s expectations for future price movements, adjusted for the cost of carry.

Can the forward price predict future spot prices accurately?

While forward prices incorporate market participants’ expectations of future spot prices, they are not perfect predictors. The actual future spot price can differ from the forward price due to unforeseen changes in market conditions, such as supply disruptions, changes in demand, or broader economic shifts. However, forward prices do offer valuable insights into market expectations and the balance of current supply and demand perceptions.

What happens if the market price at settlement is different from the forward price?

If the market price at the time of settlement is different from the forward price agreed upon in the contract, one party will incur a loss while the other gains. For example, if the market price is higher than the forward price, the buyer benefits by purchasing the asset below market price, while the seller incurs an opportunity cost. Conversely, if the market price is lower, the seller benefits at the expense of the buyer. These risks and potential rewards are inherent to entering into forward contracts and highlight the importance of carefully assessing future market conditions when negotiating forward prices.