Finance

Forward Commitments

Forward Commitments

Forward commitments are agreements between two parties to transact in the future. They specify the commodity to be sold, its price, the date of payments, and the date of delivery. Forward commitments are in several types of derivatives like forward contracts, futures, and swaps.

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How do they work?

Forward commitments are binding agreements to transact at a specified future date. When two parties want to settle or enter into a transaction in the future, there is a forward commitment. They help the two parties to decrease the risks and uncertainties about a planned transaction in the future. The forward contract specifies the transaction details like the price, delivery date, delivery method, etc. They are tradable contracts on the exchange or traded in over-the-counter (OTC) markets. Forward commitments can shield the future buying of assets or securities where two parties want to get rid of pricing volatility for a set period of time. Generally, a forward commitment is saved for products that have a time lag between creation and sale. Forward commitments are also used with loans by property builders, etc.

Types of Forward Commitments:

  • Forward contract: It is a standardized, non-exchange traded contract between two parties. It is a contract to buy or sell an underlying asset at a future specified price and date. The contract can be customizable according to the needs and requirements of both parties. The two parties can negotiate the quantity as well as the price of the commodity or asset. A forward contract specifies the buyer, seller, price of buying and selling as well as the transaction date. It is generally used for hedging due to its non-standardized nature.
  • Futures contract: A futures contract is a contract to buy or sell a security on a future date at a future price. It is similar to a forward contract except that it can be traded in an exchange. The majority of the futures market transactions have parties that have no intention of actually completing the transaction. The parties in the contract generally do not know each other. These contracts are standardized for quality and quantity to facilitate trading on the futures exchange.
  • Swaps: A swap is a forward commitment between parties agreeing to recurring transactions, a series of futures, or forward exchanges. One of the parties agrees to make a series of payments at a determined frequency to the opposite party in exchange for another set of payments. It is adjustable according to the requirements of the parties. Swaps are OTC or private contracts. The instruments can be anything but it is cash-based with a principal amount.

Forward commitment vs contingent claims:

Derivatives can either contain forward commitments or contingent claims. In a forward commitment, there is an obligation to carry out the transaction as per the agreement.  Whereas a contingent claim contains the right but not the obligation to carry out the transaction. Hence, the payoff profiles are different in both the derivatives and that in turn affects how they trade. The value of the forward commitment will move around the price of the underlying asset whereas the contingent claims value increases or decreases according to the right being exercised for a profit.

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Final Takeaway:

A forward commitment is an agreement to transact at a specified future date. They are used to reduce the uncertainty and risk of the transaction. Forward commitments are generally traded on the exchange, so the parties might not actually want to complete the transaction. It reduces the uncertainty around the underlying asset price volatility.

 

Author – Abha Shetty

About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

 

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