What is Buying Forward?
Buying forward means you agree to buy something in the future. You promise to pay a set price to get that thing on a specific future date. The thing could be an asset like gold or corn. Or it could just be an amount of cash in another currency.
The price is locked in today when you make the contract. It doesn’t change, even if the market price goes up or down before the delivery date. This is also called entering into a forward contract or a futures contract.
Why Do People Buy Forward?
People buy forward for a couple main reasons:
- To get something in the future that they know they will need. For example, an electronics manufacturer might buy copper forward. They know they’ll need a lot of copper to make their products. Buying forward locks in the price. They avoid the risk of copper costs suddenly jumping up.
- To make money if prices change in their favor. Traders “go long” by buying forward. They bet the price will rise above the forward price. If it does, they profit. They can get the asset for the lower locked-in price and immediately resell at the higher market price.
Forward Contracts vs Futures Contracts
There are two main ways to buy forward – through forward contracts or futures contracts. They work similarly but have some key differences.
Forward contracts are private deals between two parties. The terms can be customized however the buyer and seller agree. They are traded “over the counter”. This means not on a central exchange.
Futures contracts are standardized agreements traded on exchanges. The amount, quality, and delivery date are all set by the exchange. The prices are public and change frequently during trading hours. Only the price varies based on bids from buyers and sellers.
Real World Example – Buying Corn Forward
Imagine you run a company that makes tortilla chips. You need a lot of corn. The price of corn changes a lot. It depends on weather, growing conditions, supply and demand. If corn prices spike, it really hurts your profits.
To manage this risk, you could buy corn forward. You work with a supplier and enter into forward contracts. You agree on a set price to buy a certain amount of corn every month for the next year. Now your corn cost is locked in. If the market price shoots up, you’re protected.
Meanwhile, a commodities trader might buy corn futures. She thinks a drought will reduce the corn harvest in six months. Less supply will drive corn prices way up. She “goes long” by buying futures contracts at today’s price. If her prediction is right, she profits. When the contracts mature in six months, she can buy corn at the lower locked-in price. Then she can immediately resell it at the higher drought-inflated market price.
The Risk of Buying Forward
Buying forward has a major risk. The market price could move against you after you lock in your forward price.
For the chip maker, corn prices could drop way down. Now they’re stuck paying the higher forward price. Their competitors who didn’t buy forward get the savings.
For the futures trader, the drought might not happen. The corn harvest could be huge, causing prices to crash. Her long position means she has to buy high and sell low. She loses money.
The Importance of Buying Forward
Despite the risks, buying forward is an important tool. It helps many companies survive and be profitable. And it helps keep prices of essentials like food and gas more stable for everyone.
For Companies
Companies often can’t afford surprises in their costs. It’s worth giving up some potential savings for predictability. Buying key supplies forward reduces risk. It lets them plan based on stable, known costs. This leads to more consistent products, pricing and profits.
For the Market
Futures markets have another key role. They quickly integrate everyone’s knowledge about future supply and demand. Changes in forward prices send important signals. If many people expect a shortage, they will bid up futures prices now. This tells producers to make more. It tells consumers to use less or find alternatives. The sooner this happens, the less severe the shortage will be.
So in a way, buying forward doesn’t just help individual companies or traders. When lots of people do it, it makes the whole market more efficient and stable. It helps match supply and demand far in advance.
