Forward Contract

What Is a Forward Contract?

A forward contract is a customized agreement between two parties to exchange an asset at a fixed price on a specified future date. The buyer agrees to purchase, and the seller agrees to deliver, the asset at that agreed price, no matter where the market price moves in the meantime. Forward contracts are commonly used for commodities, currencies, and interest rates, though they can be written on almost any asset.

How It Works

Unlike a futures contract, a forward contract is not standardized and does not trade on an exchange. The two parties negotiate the terms directly, including the asset, quantity, delivery date, and price. Because the contract is private, it is traded over the counter, usually through banks or directly between businesses. No cash changes hands when the contract is signed. Payment and delivery happen on the agreed date, and the contract's value to each side changes as the spot price of the asset moves.

An Example

Suppose a bakery expects to need 10,000 bushels of wheat in six months and wants to protect itself from rising prices. It agrees with a grain merchant to buy that wheat in six months at a fixed price. If wheat prices rise, the bakery benefits because it pays the agreed lower price. If prices fall, the merchant benefits because it sells above market value. Either way, both parties know their cost or revenue in advance.

Advantages and Risks

Forward contracts can be tailored to exact needs, which makes them useful for hedging specific exposures. However, they carry counterparty risk, since one party may fail to meet its obligation. They also lack the liquidity and daily settlement of exchange-traded contracts, which can make them harder to exit before maturity. Forward contracts are generally used by businesses and institutions rather than individual investors, and understanding their terms and risks is an important first step before using them.