When it comes to forward contracts, there are two main types that you may encounter: long and short. While they both involve agreements to buy or sell a specific asset at a future date, there are some important differences to understand.
A long forward contract is an agreement to buy an asset at a future date for a price that is agreed upon today. This type of contract is typically used by individuals or businesses who want to lock in a specific price for an asset they plan to purchase in the future. For example, a company may enter into a long forward contract to buy a certain amount of oil at a set price in six months, in order to protect themselves from price increases.
On the other hand, a short forward contract is an agreement to sell an asset at a future date for a price that is agreed upon today. This type of contract is typically used by individuals or businesses who currently own an asset and want to lock in a price to sell it at in the future. For example, a farmer may enter into a short forward contract to sell a certain amount of wheat at a set price in six months, in order to protect themselves from price decreases.
One key difference between long and short forward contracts is the direction of risk. In a long forward contract, the buyer is exposed to the risk that the asset`s price will decrease in the future, while in a short forward contract, the seller is exposed to the risk that the asset`s price will increase. For this reason, long contracts are often used by buyers who are worried about price increases, while short contracts are often used by sellers who are worried about price decreases.
Another difference is in the timing of cash flows. In a long contract, the buyer typically pays the agreed-upon price upfront, while in a short contract, the seller typically receives payment upfront. However, the actual exchange of the asset and final payment may occur at a later date.
Overall, long and short forward contracts have some important differences, but both can be useful tools for managing risk when it comes to buying or selling assets. By understanding these differences, you can make informed decisions about whether to enter into a long or short forward contract based on your specific needs and goals.