- Broadly defined, a forward contract is an agreement between two parties to trade an asset for a designated amount of cash at some point in the future. Forward contracts have their roots in the commodities market, where farmers would agree to sell crops to manufacturers for a designated price long before harvest time. The farmer locked in a price, knew that he would make enough money to cover his costs, and hoped that the price would be higher than the going rate at the time of sale. The bank hoped that prices would go up and they would get to buy crops at a discount. In the stock market, forward contracts work the same way: sellers hope that prices drop and they earn more than the future rate, buyers hope prices will go up.
- Consider this: you hold 100 shares of a stock that you believe may lose value in the future. It's current price is $1.00. You can enter into a forward contract with a bank or other buyer to sell your stock for $1.00 three months from now, betting that the price will go down and you will make a greater profit. The buyer, on the other hand, is betting that the price will go up. If that is the case, she can resell the stock immediately and make a profit. The risk is obvious -- if you bet wrong, you can easily lose money. In some cases, stockholders use forward contracts as insurance. By creating a contract to sell at a price that earns a profit, they guarantee they will make money whether the market goes up or down. This takes on the risk that prices will skyrocket and they must sell for far less than the stock is worth.
- Forward contracts in the stock market are generally exclusive and created between two entities that have some kind of relationship. Futures contracts function on the same principal, but are more generalized. In addition, they are most likely to involve tangible assets. Rather than betting on the price of a single stock, they bet on the price of corn, oil, gold and other less volatile assets. Futures contracts trade like stocks, and the two terms may be used somewhat interchangeably.
- There is one type of forward contract that is unique and has com under scrutiny from the Internal Revenue Service. This is the prepaid forward contract. Prepaid forward contracts are exactly like regular forward contracts, but the seller receives the money right away. Generally, the IRS does not require the seller to recognize the capital gain on the sale as taxable income until the contract is complete -- that far-future maturity date on the forward contract. This means that the seller can have access to cash but delay paying taxes. The IRS becomes especially concerned if the seller then loans the stock to the buyer for trade purposes, as the trade is essentially completed but no income is recognized. In these cases, prepaid forward contracts can be considered a method of tax evasion and subject to IRS penalties.
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