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A forward commitment is an agreement to lock in a sales price for a transaction that will take place in the future. One party agrees to sell a security or offer a loan at a rate specified in the contract, as long as the buyer acts within a set period of time. Such negotiations can be used to offset risks and arrange a sales price and delivery date in advance, which can help with budgeting and priorities. A number of different kinds of securities can be sold through a forward commitment.
In the example of a loan, a borrower might approach a bank to request a loan of a particular amount at a set rate. The bank conducts a review to determine whether the borrower is eligible and promises to issue a loan with the given terms. It creates a forward commitment, agreeing to provide the borrower with the money at the quoted rate, as long as the borrower acts within the deadline. Deadlines can vary in length, depending on the type of negotiation, allowing both parties to set timelines that work for them. Banks might not want a forward commitment of more than six months, for example, because it can be hard to predict market movements.
Arranging for settlement and delivery at a date in the future can be done with stocks, bonds, and other securities. The settlement includes the agreed-upon sales price along with any associated fees and expenses. Both parties agree to adhere to their sides of the deal, whether they are providing the security or the money to buy it. Contracts establish a legal obligation to complete the transaction unless the forward commitment is allowed to expire; if the buyer fails to take action, the seller doesn’t have to provide the security at the quoted price.
Negotiations for this type of sale can include representatives of buyers and sellers as well as analysts. A careful examination of current economic conditions and projections is important on both sides to ensure that they get a good deal. Buyers want to lock in a rate that will be favorable in the future, when they can use the forward commitment to access securities at a lower price than the current market. Sellers don’t want to risk negotiating a low price and taking a loss.
One common use of forward commitments is in government-secured housing programs. These programs may work with lenders who agree to provide loans at a set interest rate as a form of security. They don’t want to insure loans that are too expensive, as this would leave the government on the hook if the borrower defaulted.