What is a Cash Forward Contract?
The cash forward contract is a financial agreement between a buyer and a seller. According to the terms of the agreement, the seller makes a covenant to deliver a specified cash commodity at a future point in time. While this type of agreement usually carries a lower level of default risk, it is important to note that a forward contract is not necessarily the right choice for every investor.
A cash market transaction of this type is very similar to a futures contract. However, there are a couple of important differences. First, cash forward contracts involve is a privately negotiated transaction. This means that the buyer and the seller are willing to bear in mind the degree of credit risk associated with both parties, and choose to assume the risk in an unregulated environment.
Second, since the transaction does not take place on the open market, the price of the cash commodities involved are not subject to the usual marking to market requirements. The buyer and the seller are free to settle on a price that is mutually agreeable, without the need to be concerned about the current state of the market. One advantage of the cash forward contract is closely related to this factor, as the agreement allows the buyer to avoid a great deal of capital outflow in the early stages of the transaction.
A third difference between the cash forward contract and a futures contract is that there is no standardized contract format that must be used for the cash forward transaction. Unlike futures contracts and their regulated sets of terms and conditions, a cash forward contract can be as simplistic or as comprehensive as the two involved parties prefer. This means there is often no lengthy process of evaluating the terms of the agreement, allowing the cash forward contract to go into effect quickly.
One important aspect of the cash forward contract to keep in mind is that the forward price named in the agreement has no real value at the time that the contract is drafted and signed. Where the value will come in is when there is a change in the underlying value of the cash commodities involved. Depending on the movement of the value of the commodity, the impact can be positive for the buyer and result in a higher value.
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