What Is a Long-Dated Forward?
A long-dated forward is a type of forward contract commonly used in foreign currency transactions with a settlement date longer than one year away and as far as 10 years. Companies use these contracts to hedge certain currency exposures.
This can be contrasted with a short-dated forward, which has expiration dates a year or less away.
- A long-dated forward is an OTC derivative contract locking in the price of an asset for future delivery, with maturities of between 1-10 years.
- Long-dated forwards are often used to hedge longer-term risks, such as the delivery of next year's crops or an anticipated need for oil a few years from now.
- Due to their longer maturities, these contracts tend to be riskier than short-dated forwards.
How Long-Dated Forwards Work
A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract is customizable to any commodity, amount, and delivery date. Further, settlement can be in cash or delivery of the underlying asset.
Because forward contracts do not trade on a centralized exchange, they trade as over-the-counter (OTC) instruments. Although they have the advantage of complete customization, the lack of a centralized clearing house gives rise to a higher degree of default risk. As a result, retail investors will not have as much access as they do with futures contracts.
Long-dated forward contracts are riskier instruments than other forwards because of the greater risk that one party or the other will default on their obligations. Further, long-dated forward contracts on currencies often have larger bid-ask spreads than shorter-term contracts, making their use somewhat expensive.
Example of a Long-Dated Forward
The typical need of a foreign currency long-dated forward contract is for businesses in need of future foreign currency conversion. For example, an import/export trade enterprise needing to finance its business. It must buy merchandise now but cannot sell it until later.
Consider the following example of a long-dated forward contract. Assume that a company knows it needs to have 1 million euros in one year to finance its operations. However, it worries that the exchange rate with the U.S. dollar will become more expensive at that time. It, therefore, enters into a forward contract with its financial institution to buy 1 million euros at $1.13 in one year's time with a cash settlement.
In one year, the spot price of euros has three possibilities:
- It is exactly $1.13: In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
- It is higher than the contract price, say $1.20: The financial institution owes the company $70,000, or the difference between the current spot price and the contracted rate of $1.13.
- It is lower than the contract price, say $1.05: The company will pay the financial institution $80,000, or the difference between the contracted rate of $1.13 and the current spot price.
For a contract settled in the actual currency, the financial institution will deliver 1 million euros for a price of $1.130 million, which was the contracted price.