What Are Forwards and Why Are They in ETFs

Understanding Forward Contracts in Your ETF

Derivatives are frequently used in ETFs. Options, futures, swaps and forwards. So it is important to understand each type of derivative so you know what is in your ETF. So in that regard, we are going to take a closer look at forward contracts.

What Is a Forward Contract?

A forward is a contract between two investors to buy and sell an asset (stock, derivative, etc.) at an agreed price on an agreed future date.

The price of the asset and the date of the future transaction are set when the forward is contracted.

No money is exchanged at the beginning of the forward contract, all monies switch hands on the agreed execution date of the forward.

Who Uses Forward Contracts?

Forwards can be contracted by any two parties, but are typically utilized by governments, companies, organizations and financial institutions.

What Happens When a Forward Contract Ends?

There are typically three ways a forward contract can be executed…

  • The asset is exchanged for the agreed price
  • A cash equivalent of the underlying asset can be exchanged
  • A new forward contract can be created

As long as both parties that under contract agree to the cash equivalent, that option can be utilized. If not, the original forward contract agreement is to be honored, unless the entire agreement is rolled into a new forward contract.

What Are the Risks Associated with Forwards?

Forward contracts always have default risk – risk that one of the parties will not meet the agreed obligations.

And because forward contracts are not regulated, there is always an increased default risk associated with forwards vs. other derivatives.

Also, sometimes a party may want to terminate the contract before expiration. At that point, both parties can agree on the deliverable, settle on a cash equivalent for the underlying asset or even roll into a new forward contract position.

What Are the Differences Between Forwards and Futures?

Futures contracts and forward contracts are similar in nature, but there are quite a few differences. As I said above, forwards are not regulated by any overseeing organization, whereas futures are highly regulated by the SEC (Securities Exchange Commission). That’s why forwards have default risk.

Also, forwards are private contracts between two parties, whereas futures are public contracts and can trade on secondary exchanges. And since futures are currently traded on public exchanges, there is more liquidity for the contracts. An investor has more options to trade in and out of futures positions. So a forward contract has more liquidity risk as well as default risk.

What Are the Assets Used in a Forward Contract?

Technically forwards can be contracted on any asset, but typically (in the financial world) the assets are stocks, bonds, currencies, foreign securities, indexes, and interest rates. But again, a forward can be for any asset, not just the ones I listed.

Are Forwards Used in All ETFs?

No, not every ETF contains forward contracts or even derivatives for that matter. Some ETFs can contain just equities and cash, or even other ETFs.

However, there are plenty of ETFs that do use derivatives to help them track benchmarks. Inverse and leveraged ETFs are examples of funds that utilize forwards and other derivatives.

So, if there are forwards or other derivatives in any ETFs you are considering for your portfolio (or already own), make sure you are aware of how they work and the impact on your fund. And if you have any questions, do not hesitate to contact your financial advisor, broker or a financial professional.