Understanding Forward Contracts

Let’s consider arguably the most basic derivative, and almost certainly, the oldest: the forward contract.  

The good news is that you already understand the economic concepts at work in a forward, that is, if you have ever been a part of a basic real estate transaction!  

Consider the most basic land deal:  I agree to buy your land on a particular date in the future but at a price we set today.  But, it could be correctly asked, if I want your land, why wouldn’t I just buy it today, if we have agreed on the price?  Well, you can do that of course and nothing stops me from giving you cash and you giving me a deed and the keys to the gate.  

But, since I may not know your land well, I might need some time to inspect it.  I also need some time to find the money to pay for your land.  And, if the market we are in is active, I want to get a contract with you to buy your land now, even if I am not quite ready to close the deal at this moment.  I want to encumber your land, and I want to know the price I will pay at closing – in the future.    

So for these and other reasons, we agree in a contract that I will pay for your land on a certain date in the future, and you will give me a deed and the keys to the gate on that day.  

In the meantime, of course, if I find that the land doesn’t work for me, or I can’t get a loan, then I will have negotiated the right to terminate the contract – up to a certain date.  If I terminate, neither party has any further obligation.

This is all that a forward contract is! And a forward contract can be for any commodity or asset. 

The derivative textbook definition is as follows:  a buyer and a seller agree to buy or sell an asset on a future date, but at a price set today.  What makes it complicated (well, to me at least…perhaps this is all obvious to you), is that the thing to be bought or sold at that future date, may not exist today.  This is where the real estate analogy breaks down.

But this is also why the forward contract arose in the agricultural context.  You agree to buy my agricultural yield, on a future date set, at a particular location and for a particular price.  It is a fairly straightforward and intuitive way to deal with market uncertainties in agriculture, and thus to spread risk, finance an important industry, and to facilitate trade between regions with unique agricultural capabilities and distinct yields.

Indeed, Aristotle notes in his Politics that Thales of Miletus anticipated a good olive harvest one particular year, and acting on his speculation, he contracted for the right to use olive presses in the future for a price set today.  The olive press owners then knew that they would have some business, and Thales could be first in line to use those presses when the abundant harvest came.  Every other olive producer had their glee at the abundant harvest turn to frustration as they showed up at the olive press, only to have to wait in a long line!  (“Thales, tell me again why you’re first in line?”).

So Thales was just an early forward contract utilizer.  By the medieval era in Europe, the forward contract was widely used to facilitate pan-European trade.

And again, if you have ever been involved in buying or selling real estate, you have utilized what is conceptually nothing more than a forward contract.  You know more about derivatives than you realized! Congratulations!

Next we will make this more interesting by introducing futures contracts, and the booking of hotel rooms – something else which you are already familiar with!