What Is a Forward Forward?
Forward forward agreements, also known as forward rate agreements, are a type of financial contract in which two parties agree to enter into a loan transaction at a future date. The party borrowing the funds agrees to repay the principal amount along with a premium, upon maturity of the loan.
Although forward forwards do not involve period interest payments, the premium paid at the end of the contract effectively compensates the lender for the risk involved in providing the loan.
- A forward forward is a contract in which two parties agree to enter into a loan agreement at a future time.
- The loan agreement requires the borrower to repay the principal amount upon maturity of the loan, along with an additional premium.
- Forward forward are a special type of forward contract, which are widely used in modern financial markets.
Understanding Forward Forwards
In finance, the term "forward" is often used to describe agreements to conduct a transaction at a future date. A forward contract, for example, entails an agreement to purchase an asset at a future date at a specified price called the forward price. By contrast, spot transactions—also known as cash transactions—are ones which occur immediately at the prevailing spot price.
Forward forwards are simply a special type of forward transaction in which the parties agree to enter into a loan agreement at a future date. Unlike a typical loan in which the borrower will obtain funds today and repay them in the future, a forward forward states that the borrower will borrow funds in the future and repay them at a still later time.
For instance, a borrower might enter into a forward forward agreement with a lender on Jan. 1. According to the terms of their agreement, the borrower might receive the principal amount on March 1 and agree to repay the principal, plus a premium, on Dec. 31.
Forward contracts are a widely used mechanism throughout modern finance. They are similar to futures contracts, except unlike futures they are traded over-the-counter (OTC). This means that forward agreements can be highly customized by the parties involved. Although they often share similar features, any two forward contracts are unlikely to be exactly alike. Futures, meanwhile, are standardized contracts that trade on exchanges. As such, there is far less variation between contracts.
The fact that forwards are traded in OTC markets offers both advantages and drawbacks. Although they provide virtually unlimited flexibility to the parties involved, forwards are less regulated than futures and do not benefit from the institutional support of clearing houses or exchanges. Consequently, participants in forward transactions can be highly exposed to counterparty risk; if the party with whom they are trading defaults on their obligations, the wronged party may have little or no practical recourse outside of litigation.
Real World Example of a Forward Forward
One particularly relatable example of a forward forward agreement is actually a traditional mortgage loan. These traditional or "forward" mortgage loans involve a mortgage lender, typically a bank, agreeing to extend an individual a residential mortgage loan at a predetermined closing date. The mortgage holder, in turn, agrees to pay back the mortgage principal and interest every month for a set period, typically 15 or 30 years.
By contrast, a reverse mortgage generates a monthly payment to a homeowner who has completely paid off their forward mortgage. These reverse mortgage payments accrue a balance against the value of the home that must be repaid after death by the homeowner's heirs, either through a lump sum or through the sale of the home.