What is a forward contract?
A forward contract is an agreement whereby two parties undertake, on a given day, to enter into a future transaction for the purchase or sale of a specific asset – such as a currency, commodity or stock – at a predetermined price. It is characterized by the lack of standardization and the possibility of adapting the terms to the needs of the parties. The price agreed on the day of the contract allows protection against market movements, although at the same time there is a risk of non-payment by the counterparty.
Frequently asked questions (FAQ)
1. What is the difference between a forward contract and a futures contract?
A forward contract is entered into directly between two parties (OTC) and has individually negotiated terms, whereas a futures contract is standardized and traded on a commodity exchange. Futures are subject to daily settlement and margin requirements, while forward contracts are not.
2. What commodities do forward contracts in the food industry typically hedge?
The most common are commodities with high price volatility, such as milk powder, whey, vegetable oils, sugar, cereals, vegetable proteins and dairy fats. Forward contracts allow companies to hedge the prices of these commodities for future periods.
3. Who uses forward contracts?
Forward contracts are used both by producers (e.g. dairies, feed processors) and by distributors or trading companies (e.g. Foodcom S.A.) who wish to reduce their price risk and plan their buying or selling operations in advance.
4. What are the main advantages of taking out a forward contract?
- Price and margin protection against market fluctuations.
- Better planning of budgets and operating costs.
- Possibility to establish stable long-term relationships with counterparties.
- Greater predictability with large trading volumes.
5. What are the risks associated with a forward contract?
The biggest risk is that the counterparty will default on the contract (known as credit risk). In addition, if the market price falls below the price agreed in the contract, the buyer will pay more, which may reduce its current competitiveness.
6. How is a forward contract settled?
Usually not. Unlike futures contracts, forward contracts are not settled daily and do not require margin. In practice, however, some companies may establish an advance or a form of collateral to minimize the risk of non-payment.
7. Can a forward contract be terminated early?
Settlement takes place on the date agreed in the contract: it may take the form of physical delivery of the goods (so-called physical delivery) or settlement of the difference between the market price and the agreed price (so-called cash settlement).
