Forward Contract

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Forward Contract

A forward contract is a private, customizable agreement between two parties to buy or sell an asset at a specified price on a future date. Commonly used for hedging, forwards allow counterparties to lock in prices for commodities, currencies, or interest-rate exposures. Because they are negotiated over-the-counter (OTC) rather than traded on an exchange, forward contracts are flexible but carry higher counterparty and settlement risk.

Key takeaways

  • A forward contract fixes a future transaction price for an asset agreed today.
  • Forwards are OTC and customizable (asset type, quantity, delivery date, cash vs. physical settlement).
  • They do not undergo daily mark-to-market; settlement occurs at contract maturity.
  • The OTC nature increases default risk compared with exchange-traded futures.
  • Corporations and financial institutions commonly use forwards to hedge currency, commodity, and interest-rate risk.

How a forward contract works

  • Parties agree today on: the underlying asset, the forward price, the quantity, and the settlement/delivery date.
  • Settlement can be physical (delivery of the asset) or cash (a payment equal to the difference between the spot price at maturity and the agreed forward price).
  • No centralized clearinghouse is involved; performance depends on each party’s creditworthiness.

Comparison with futures contracts

  • Standardization: Futures are standardized contracts traded on exchanges; forwards are customized OTC agreements.
  • Clearing and margining: Futures are cleared through exchanges and marked-to-market daily with margin requirements, reducing credit exposure. Forwards settle only at maturity, so exposures can accumulate.
  • Accessibility: Futures are generally more accessible to retail investors; forwards are typically used by corporations and large institutions.
  • Flexibility: Forwards offer greater flexibility in contract terms, which can be important for bespoke hedging needs.

Example

An agricultural producer expects to sell 2,000,000 bushels of corn in six months and worries prices may fall. The producer enters a cash-settled forward contract to sell 2,000,000 bushels at $4.30 per bushel in six months.

Possible outcomes at maturity:
* Spot = $4.30 per bushel: No payment changes hands; the contract closes unchanged.
* Spot = $5.00 per bushel: The producer pays the counterparty (long) the difference: ($5.00 − $4.30) × 2,000,000 = $1,400,000. The producer’s forward position offsets the higher market price the producer did not capture.
* Spot = $3.50 per bushel: The counterparty pays the producer: ($4.30 − $3.50) × 2,000,000 = $1,600,000. The forward offsets the producer’s loss from the price decline.

Risks

  • Counterparty/default risk: Because forwards are OTC, one party may fail to perform at settlement.
  • Settlement risk: Without daily mark-to-market, large exposures can build if market prices move significantly.
  • Liquidity and opacity: The forward market is less transparent and less liquid than exchange-traded markets, making valuation and exit more difficult.
  • Concentration risk: In stressed markets, cascading defaults are possible if counterparties are highly interconnected.

Common uses and risk management

  • Uses: Hedging commodity prices, foreign exchange exposure, and interest rate risks; bespoke financing or speculative positions for sophisticated parties.
  • Risk management practices: Credit screening, collateral or margin agreements, netting arrangements, and standardized legal documentation (e.g., ISDA-type agreements) are commonly used to reduce counterparty exposure.

Summary

Forward contracts provide a flexible, tailor-made tool for locking in future prices and managing specific exposures. Their customization is valuable, but the absence of an exchange clearing mechanism and mark-to-market requires careful counterparty assessment and contractual safeguards to manage default and settlement risks.