What is Buying Forward?
Buying forward is when an investor negotiates the purchase of a commodity at a price negotiated today but takes actual delivery at some point in the future. Investors and traders buy forward when they believe the price of a commodity is going to increase in the future. The concept of buying forward commonly applies to currencies as well as commodities, and can also be done for almost any security using a forward contract.
Understanding Buying Forward
Buying forward is a strategic decision an investor may make when he or she anticipates a rise in prices or an increase in the demand levels for a particular good or security. Buying forward allows the investor to take advantage of future rise by locking up the commodity or security at a lower price now and then selling when prices rise. Depending on how buying forward is done, the contract to purchase the good or security can be sold to another party that is taking actual delivery.
How Buying Forward is Done
Buying forward used to involve buying a good when it was plentiful, stockpiling it and then selling when the supply dwindled. This could be done for some commodities, but not all. The market evolved over time and the forward contract replaced much of the physical stockpiling. A forward contract is a customized contract between two parties that specifies the asset to be purchased at a later date, along with the agreed-upon price.
Forward contracts can have a strong impact the market for a particular good because they influence production of many goods. For example, the meat and livestock tends to see seasonal production gluts and dips due to the natural breeding seasons. If, however, producers see a lot of buying forward through contracts, they can alter their breeding cycles to fall in line. This type of buying forward usually requires paying a premium to incentivize off-season production at first, but over time the clear market signal will benefit both buyers and sellers.
Buying Forward Versus Buying Futures
In contrast with standard futures contracts, a forward contract can be customized to any commodity, amount, and delivery date, and is generally a private arrangement. This makes forward contracts less readily available to the retail investor than futures contracts. Because forward contracts do not generally trade on public exchanges, they are considered over-the-counter (OTC) instruments.
While futures contracts are standardized, trade on major exchanges, and have clearing houses that guarantee the timely and complete delivery of the transactions; forward contracts lack a centralized clearinghouse and therefore can pose a higher degree of default risk.
Forward contracts settle on one date at the end of the contract, while futures contracts can settle over a range of dates. In addition, a forward contract settlement can occur on a cash or delivery basis.