What Is a Short Term Contract?
A short term contract is a legally binding agreement between two or more parties that establishes terms and conditions for a transaction or activity, with a defined duration typically less than one year. These agreements fall under the broad umbrella of financial instruments and are characterized by their brief maturity periods, which distinguishes them from agreements that extend over many years. Businesses and investors frequently use short term contracts for various purposes, including managing immediate cash flow needs, speculating on near-term price movements, and mitigating specific risks. The brevity of a short term contract often implies a quicker settlement or fulfillment of obligations compared to longer-duration agreements.
History and Origin
While the concept of future-dated agreements can be traced back to ancient civilizations, modern short term contracts, particularly in finance, gained prominence with the development of organized markets. Early forms of contracts for future delivery existed in 13th and 14th century Europe for commodities like wool and in 17th century Japan for rice at the Dojima Rice Exchange. In the United States, the formalization of these agreements began in the mid-19th century. The Chicago Board of Trade (CBOT), founded in 1848, initially served as a cash market for grain. However, it quickly evolved, introducing standardized "to-arrive" contracts and later, in 1864, the first standardized futures contracts. This standardization was a crucial step in creating liquid, transparent markets for what would become sophisticated short term financial instruments.4
Key Takeaways
- A short term contract is a binding agreement with a maturity period typically under one year.
- These contracts are vital for managing immediate financial needs, facilitating quick transactions, and addressing short-term market exposures.
- Common examples include certain types of derivatives, money market instruments, and specific lending agreements.
- Their short duration often implies lower default risk and higher liquidity compared to long-term alternatives.
- However, they are also subject to specific risks, such as interest rate fluctuations and rollover risk.
Interpreting the Short Term Contract
The interpretation of a short term contract largely depends on its specific type and the context in which it is used. For instance, a short term loan agreement between a business and a bank defines the repayment schedule, interest rate, and covenants for a period of months. In financial markets, understanding a futures contract or an options contract involves analyzing their expiration date, underlying asset, and agreed-upon price. The primary focus for interpreting any short term contract is its limited time horizon, which impacts valuation, risk exposure, and potential for quick capital deployment or repayment. Due to their brief nature, they are often used in contexts requiring rapid adjustments to market conditions or immediate financial needs.
Hypothetical Example
Consider a small manufacturing company, "Widgets Inc.," that anticipates receiving a large payment from a client in two months. However, the company needs to purchase raw materials immediately to fulfill new orders. Widgets Inc. decides to enter into a short term contract in the form of a 60-day loan from its bank to cover this working capital need.
The terms of the short term contract are:
- Principal Amount: $100,000
- Interest Rate: 5% annual simple interest
- Maturity Date: 60 days from the contract start date
- Collateral: Accounts receivable from the client
Upon signing this short term contract, Widgets Inc. receives the $100,000. After 60 days, when the client payment is received, Widgets Inc. repays the principal plus interest. The total interest paid would be calculated as: ($100,000 \times 0.05 \times (60/365) \approx $821.92). This short-term financing allows the company to maintain its production schedule without disrupting its cash flow, demonstrating the practical utility of such agreements for bridging temporary financial gaps. This scenario highlights how short-term borrowing can be a key component of effective risk management for businesses.
Practical Applications
Short term contracts are ubiquitous across various sectors of finance and commerce. In the money market, they are foundational. Instruments like Treasury bills, commercial paper, and repurchase agreements are quintessential examples of short term contracts that enable governments and corporations to raise funds for immediate needs. Money market funds, which are mutual funds that invest in these highly liquid, short-term assets, are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, with Rule 2a-7 specifically aiming to limit their liquidity risk.3
In the derivatives market, short term contracts such as futures contracts and options contracts are heavily utilized for hedging against price fluctuations or for speculative purposes. For example, a farmer might use a short term futures contract to lock in a price for their crop before harvest. The Commodity Futures Trading Commission (CFTC) sets position limits for various commodity derivative contracts, including many physically-settled short-term futures, to prevent excessive speculation and maintain market integrity.2 Furthermore, short term forward contracts are common in foreign exchange markets for locking in exchange rates for future transactions, providing certainty for international trade. Even in general contract law, agreements for services or deliverables with defined, brief completion periods are considered short term.
Limitations and Criticisms
Despite their utility, short term contracts are not without limitations. One primary concern is rollover risk, where an entity relying on short-term financing faces the risk that they may not be able to renew their contracts or loans at favorable rates, or at all, when they mature. This risk became evident during the 2008 financial crisis and again during the onset of the COVID-19 pandemic in March 2020, when the Federal Reserve established facilities like the Money Market Mutual Fund Liquidity Facility (MMLF) to stabilize short-term funding markets and stem investor outflows from money market funds.1
Another limitation is interest rate risk, as short term contracts are highly sensitive to changes in prevailing interest rates. While this can be advantageous if rates fall, it exposes parties to increased costs or reduced returns if rates rise rapidly. For investors, the frequently lower yields on short-term instruments compared to long term contracts might be seen as a drawback, especially in periods of low interest rates, potentially limiting their opportunities for arbitrage. Additionally, the transactional costs associated with frequently entering and exiting short term contracts can accumulate, eroding profitability for active traders.
Short Term Contract vs. Long Term Contract
The fundamental difference between a short term contract and a long term contract lies in their duration and the implications stemming from that duration.
A short term contract is characterized by a relatively brief lifespan, typically less than one year. These agreements are often favored for their flexibility, higher liquidity, and ability to address immediate needs or capitalize on near-term market movements. Examples include treasury bills, commercial paper, or certain derivative contracts with close expiration dates. They tend to have lower exposure to long-term uncertainties like sustained inflation or prolonged economic downturns, but are more susceptible to rollover risk and short-term interest rate volatility.
In contrast, a long term contract extends for a year or more, sometimes spanning decades. These contracts are generally used for significant commitments, such as capital projects, long-term leases, multi-year supply agreements, or large infrastructure financing. While they offer stability and predictability over an extended period, they also carry greater exposure to long-term risks like sustained inflation, shifts in market demand, or changes in regulatory environments. Long-term agreements often involve more complex legal frameworks and due diligence, reflecting the extended commitment and potentially larger financial implications.
The confusion between the two often arises from the specific financial instrument being discussed; for example, a loan can be short-term or long-term depending on its repayment schedule, and even derivative products can have varying maturities. The key differentiator remains the agreed-upon duration of the obligations.
FAQs
What are common examples of short term contracts in finance?
Common examples include commercial paper, repurchase agreements, Treasury bills, certain money market instruments, and derivative contracts like futures contracts and options contracts with nearby expiration dates. These are typically used for managing short-term financial needs or market exposures.
Why would a company use a short term contract instead of a long term one?
A company might use a short term contract to address immediate working capital needs, bridge temporary cash flow gaps, or to gain exposure to an asset for a limited period without a long-term commitment. They offer greater flexibility and can be less costly than long-term alternatives for temporary needs.
Are short term contracts always less risky than long term contracts?
Not necessarily. While they generally have lower interest rate risk over their short life and often higher liquidity, short term contracts are highly susceptible to "rollover risk" if they need to be renewed in an unfavorable market environment. They can also be very volatile, especially in the case of short-dated derivative contracts used for speculation.