Forward
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified price on a future date.
It’s called “forward” because the delivery and payment happen in the future, not now.
Formula in words:
“We agree today on the price, but the exchange happens later.”
Key Characteristics
| Feature | Description |
|---|---|
| Customization | Terms (price, quantity, date) are tailored to both parties. |
| Private contract (OTC) | Not traded on an exchange — done over-the-counter (OTC). |
| Obligation | Both buyer and seller must honor the contract on the settlement date. |
| No upfront payment | Typically, no money changes hands when the deal is made. |
| Settlement | Can be done by physical delivery (actual asset) or cash difference. |
How It Works — Example
Imagine you are a farmer growing 100 tons of wheat.
- Current market price (today): $300 per ton
- You worry prices might fall by harvest time.
- A bakery agrees to buy your wheat at $310 per ton, 3 months from now.
That agreement is a forward contract.
On settlement day:
- If market price = $250/ton → You gain $60/ton because you sell at $310.
- If market price = $350/ton → You lose $40/ton because you must sell at $310.
So both sides have locked in certainty, removing price risk.
Who Uses Forward Contracts?
| User | Why They Use It |
|---|---|
| Farmers / producers | Lock in selling prices of crops, oil, metals, etc. |
| Manufacturers | Lock in purchase prices of raw materials. |
| Importers / exporters | Fix exchange rates for future payments. |
| Investors / traders | Speculate on future price changes. |
| Banks / institutions | Offer customized forward contracts to clients (e.g., FX forwards). |
💱 Example: Currency Forward
Suppose an Australian company needs to pay USD 1 million to a U.S. supplier 3 months from now.
- Today’s rate: 1 USD = 1.55 AUD
- The company fears the AUD may weaken (making USD payments more expensive).
- It signs a forward contract with a bank to buy USD at 1.55 AUD per USD in 3 months.
No matter what happens to exchange rates:
- If AUD falls → the company saves money.
- If AUD rises → it loses a bit, but the rate was locked and predictable.
Result: Stable cash flow and cost certainty.
Settlement Methods
| Type | Description |
|---|---|
| Physical settlement | The asset is delivered and paid for at the agreed price. |
| Cash settlement | No delivery — just the profit or loss difference is paid. (Common in finance and commodities). |
Risks of Forwards
| Risk | Explanation |
|---|---|
| Counterparty risk | The other party might default (since it’s OTC, not exchange-traded). |
| Liquidity risk | Hard to sell or transfer before expiry. |
| Mark-to-market risk | Value can fluctuate, but no daily settlement like futures. |
| No standardization | Customization makes it less transparent or tradable. |
Forward vs. Future
| Feature | Forward | Future |
|---|---|---|
| Trading venue | OTC (private deal) | Exchange-traded |
| Customization | Fully customized | Standardized |
| Counterparty risk | High (private) | Low (exchange guarantees) |
| Daily settlement | No | Yes (marked to market daily) |
| Liquidity | Low | High |
| Common use | Hedging, corporate risk management | Trading, speculation |
In Summary
A Forward Contract = an agreement today to buy/sell later at a set price.
It’s flexible, private, and powerful — but also riskier than exchange-traded futures.