Forward rates are the rates an investor will pay for a stock, or other security, when purchasing a futures contract. The buyer is essentially locking in at a price now to purchase commodities, currency, stocks, or other assets, at a later date. Both the buyer and seller are making a legal commitment to complete a sales transaction on a specific date in the future.
For example, a farmer wants to ensure the price he will get for his wheat harvest. The farmer can offer a futures contract to an investor before the harvest. When an investor buys this contract, the investor is locking in the price and so is the farmer. When the wheat is harvested later, the owner of the contract is obligated to purchase the wheat at the forward rate that was listed in the contract.
A forward rate is usually determined by several factors. These factors can include costs for the seller to maintain ownership of the item to be sold, the item's anticipated appreciation, and supply and demand. When forward rates are offered, both the buyer and seller are making predictions about what will happen to the price of the asset being sold.
If the price goes up, the seller will get a bargain when purchasing assets with forward rates. Conversely, if the prices of the asset go down, the seller will make a bigger profit by selling the assets using the forward rates. As a result, participating in futures contracts is sometimes known as hedging.
A futures contract is a legally binding agreement. The futures contract will list both the rate, or price of the asset, and usually includes the sale date. Forward rates are generally only good for a specific amount of time. The investor must make a purchase within the time frame allowed to get the forward rate listed in the contract.
Futures contracts that list forward rates must be fulfilled. The holder of a futures contract does have options however. If the buyer does not wish to purchase the assets, the buyer can sell the contract to another investor. Futures contracts can be bought and sold on most exchanges.
Futures contracts are most often used by large institutional investors. Individual investors can also participate in futures contracts. The small investor must be prepared to fulfill the contract if it cannot be sold by the sale date listed in the contract. Both the buyer and seller must be prepared to accept the price listed in the contract, no matter what happens to the price of the commodity before the contract matures.