What Is Forward Commitment?
A Forward Commitment refers to a contractual agreement signed between two parties to perform a transaction on a future date. It enables both parties to minimize uncertainties and risks, particularly the risk concerning price volatility associated with a planned transaction.
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Source: Forward Commitment (wallstreetmojo.com)
These agreements vary in terms of the exact contracting mechanism and structure. They specify the goods or commodities sold, delivery date, payment date, price, and other transaction-related details. Examples of such contractual agreements are swaps, futures, and forward contracts. One can trade them as contracts on exchange markets or via OTC or over-the-counter markets.
Table of contents
- What Is Forward Commitment?
- Forward Commitment Explained
- Forward Commitment Derivatives
- Examples
- Advantages
- Forward Commitment vs. Contingent Claim vs. Forward Funding
- Frequently Asked Questions (FAQs)
- Recommended Articles
Key Takeaways
- The forward commitment refers to an agreement in which the parties involved are obligated to transact at a predetermined price on a specific date. It reduces the uncertainty associated with the transaction.
- A key benefit of these agreements is that they offer the parties a sense of security.
- Such contractual agreements cover three kinds of derivatives. They are futures contracts, swaps, and forward contracts.
- A key difference between forward commitment and contingent claim is that the former involves an obligation to carry out the transaction on a fixed date, unlike the latter.
Forward Commitment Explained
The forward commitment refers to a contract in which one party agrees to purchase while the other accepts to sell an asset at a predetermined price on a future date. It particularly minimizes the price volatility risk related to the planned transaction. When two persons intend to settle or enter into a transaction on a future date, they implicitly or explicitly enter into this agreement. In essence, this agreement indicates the commitment to purchase or sell.
As noted above, one can trade such contractual agreements as derivative contracts, specifically, futures contracts traded on exchanges. Hence, the contract between the end customer and producer may trade between two parties with no interest in taking the underlying asset’s delivery.
These agreements are closely connected to commodities owing to their massive usage in futures markets. Nevertheless, one must remember that this term typically applies to all arrangements where two persons involved in a contract agree to a future transaction’s terms well before the date of the transaction.
Forward commitment agreements can include the future purchase of any financial product or asset where both parties wish to eliminate price volatility for a certain duration. Usually, such agreements are reserved for products involving a time lag between their creation and sale, for example, commodities that are harvested or extracted.
The use of such an agreement is also common for loans. For instance, property builders can enter into this type of contractual agreement the set the loan terms and interest rate before they actually require financial assistance for the development process. This offers the borrower the security of knowing they can access the funds when required. At the same time, it provides the loan provider with the ability to make predictions regarding business in the future more accurately.
Forward Commitment Derivatives
Forward commitment derivatives are as follows:
#1 – Forward Contracts
A forward contract is an arrangement between a couple of transacting parties. One cannot trade them on exchanges. Such contracts specify the seller’s and buyer’s identity, transaction price, and transaction date.
#2 – Swaps
Parties enter into this type of forward commitment agreement for the purpose of exchanging recurring transactions, future cash flows, or a number of forward contracts. Parties can customize such contracts to accommodate their requirements concerning the transaction involved. One must remember that individuals cannot trade swaps because they are private, off-the-counter agreements or contracts.
#3 – Futures Contracts
Futures contracts are like forward contracts. However, individuals can buy and sell them on organized exchanges, unlike the latter. These contracts also specify the transaction price, date of transaction, and the buyer’s and seller’s identity. In the futures market, many transactions involve persons who do not intend to complete the transaction, i.e., they do not intend to take delivery of the product.
Examples
Let us look at a few forward commitment examples to understand the concept better.
Example #1
Suppose Jim, a wheat producer, is aware that he must sell the crop following harvest. If he enters into a futures contract along with a forward commitment, it will enable him to get a purchaser in advance and set a sale price for a certain date in the future.
Example #2
In October 2022, Freddie Mac disclosed that it would raise financing for heavily rehabbed or newly constructed multifamily housing. This organization will leverage new Federal Housing Finance Agency or FHFA-granted flexibilities that allow more usage of forward commitments. Such contracts will allow the purchase of loans at a future date with specific financing terms set beforehand.
Thus, the agreements will offer more certainty to housing developers and construction lenders by mitigating the risks they face when they execute complicated multifamily deals in a volatile market.
Advantages
The benefits of such agreements are as follows:
#1 – Cost Benefits
These contractual agreements allow the parties involved to lock in or fix the current interest rates that must be transacted on a specific date in the future. It offers an essential cost advantage to both parties involved because the factors of uncertainty and speculation associated with the interest rates and future exchange are removed, along with the likelihood of future price volatility.
#2 – Security
When both parties agree to carry out a transaction at a future date, it provides them with a sense of security. The seller becomes certain that they will receive payment on a certain date in the future, and the buyer is also aware that they must pay the amount on that date. Moreover, the purchaser also gets adequate time to arrange the money required to complete the transaction.
#3 – Certainty
Such contracts come with the benefit of security and certainty that the transaction will occur. Per requirement, they must exclusively specify every detail concerning the planned transaction. Since the parties involved already agree to all details regarding the future transaction beforehand, they achieve a sense of certainty and security. Moreover, all speculations concerning uncertainty or unforeseen events are removed from that transaction.
Forward Commitment vs Contingent Claim vs Forward Funding
Forward funding, forward commitment, and the contingent claim can be confusing for individuals unfamiliar with these concepts. One must know how they differ to understand their meaning clearly. So, let us look at some of their distinct characteristics.
| Forward Commitment | Contingent Claim | Forward Funding |
|---|---|---|
| This is a contract that requires two parties to carry out a transaction at a certain price on a prespecified date in the future. | A contingent claim refers to a derivative having a payout that depends on the realization of a future event that is uncertain. | In the case of forward funding, a promoter transfers the property’s ownership to the investor. However, the taxes, costs, and risks associated with it are transferred once the property is complete. |
| In the case of this arrangement, the parties have an obligation to perform the transaction according to the predetermined terms. | It involves the right to perform the transaction, but there is no obligation. | The investor is interested in taking delivery of the asset. Whereas, in the case of a forward commitment agreement, one may not have any interest in taking delivery of the underlying asset. |
Frequently Asked Questions (FAQs)
In lending, this contractual agreement refers to a pledge that a loan provider will honor the loan obligation sometime in the future if the prospective borrower meets specific conditions. Typically, the forward is an entirely underwritten loan commitment having predetermined interest rates, terms, proceeds, and loan documents.
In statistical standards, credit default swaps or CDS are dealt with like option-type financial derivatives. That said, they have specific features of forward-type derivatives. The primary one being a CDS contract can switch to a liability from an asset and vice versa, depending on the reference entity’s credit quality.
Yes, it is a legally binding contractual agreement between two parties to carry out specific actions at a future date.
A futures contract is a kind of forward commitment. That said, unlike swaps and forward contracts, one can trade this derivative on exchanges.
Recommended Articles
This has been a guide to what is Forward Commitment. We compare it with forward funding & contingent claim, explain its examples, derivatives, & advantages. You can learn more about it from the following articles –
- Borrowing Capacity
- Spot Exchange Rate
- Kiting
This post first appeared on Free Investment Banking Tutorials |WallStreetMojo, please read the originial post: here
