Forward Delivery: What it Means, How it Works, Example

What Is Forward Delivery?

Forward delivery is the final stage in a forward contract when one party supplies the underlying asset and the other pays for and takes possession of the asset. Delivery, price, and all other terms must be written into the original forward contract at its inception.

Understanding Forward Delivery

Forward delivery is when the underlying asset is delivered to the receiving party in exchange for payment.

A forward contract is a contract between two parties to buy or sell an asset at a specified price on a future date. Forward contracts are used for hedging or speculation. A forward contract can be customized for any asset, for any amount, and for any delivery date. The parties can settle in cash, paying out the net benefit/loss on the contract, or deliver the underlying. When the contract settles in delivery of the underlying asset, that final stage is called forward delivery.

The forward contracts market is large, as many corporations use forwards to hedge interest rate risks and currency fluctuations. The actual size of the market can only be estimated since forwards don't trade on exchanges and are typically private deals.

The main problem with the forward contract market is counterparty risk. One party may not follow through on their half of the transaction and that could lead to losses for the other party.

Forwards Vs. Futures

Because futures contracts are standardized and traded on exchanges, counterparty risk is mitigated by the exchange's clearing mechanism. Further, there is a ready trading market should either the buyer or the seller decide to close out their position ahead of expiration. This is not the case with forwards.

Tighter regulation of futures ensures a fair market, and daily mark to market protects traders from running up huge, unrealized losses. Margin requirements prevent this. Again, forwards don't have this. Forward contracts trade over the counter with fewer safeguards.

Another important difference is the upfront cost. The buyer of a futures contract must maintain a portion of the cost of the contract in the account at all times, referred to as margin. The buyer of a forward contract does not necessarily have to pay or put any capital upfront but is still locked into the price they will pay (or the amount of asset they will have to deliver) later.

Because of the increased counterparty risk, the seller of the forward contract could be stuck with a large amount of the underlying asset should the buyer fail to meet their obligations. This is why forwards typically trade between institutions with solid credit and that can afford to meet their obligations. Institutions or individuals with poor credit or who are in poor financial situations will have a hard time finding institutions to conduct forwards with them.

Forward Delivery Example

Assume a simple situation in which Company A needs to buy 15,236 ounces of gold one year from now. A futures contract isn't that specific, and buying so many futures contracts (each representing 100 ounces) could incur slippage and transaction costs. Therefore, Company A chooses a forward over the futures market.

The current price of gold is $1,500. Company B agrees to sell Company A 15,236 ounces of gold in one year, but at a cost of $1,575 an ounce. The two parties agree on the price and the date of delivery. The forward rate, which is higher than the current rate, factors for storage costs while the gold is being held by Company B and risk factors.

In one year, the price of gold could be higher or lower than $1,575, but the two parties are locked in at the $1,575 rate.

Forward delivery is made by Company B providing Company A with 15,236 ounces of gold. In exchange, Company A provides Company B with $23,996,700 (15,236 x $1,575).

If the current rate is higher than $1,575, then Company A will be happy they locked in the rate they did, while Company B won't be so happy.

If the current rate is lower than $1,575, then Company A could have been better not entering into the contract, but Company B will be happy they made the deal.

That said, typically these types of deals are not meant to speculate, but rather lock in a rate on an asset that is required in the future.