Forward Contract
Quick Definition
A customized private agreement between two parties to buy or sell an asset at a specified price on a future date, traded over-the-counter.
What Is Forward Contract?
A forward contract is a private, customizable agreement between two parties to buy or sell an underlying asset at a predetermined price (the forward price) on a specified future date. Unlike futures contracts, forwards are traded over-the-counter (OTC) rather than on exchanges, allowing complete customization of terms including size, delivery date, and settlement method. However, this flexibility comes with counterparty risk — the risk that one party will default on the obligation. Forwards are widely used by corporations to hedge foreign exchange exposure, commodity prices, and interest rate risk. They do not require margin deposits or daily mark-to-market settlement like futures. At inception, a forward contract has zero value; it gains or loses value as the spot price of the underlying moves relative to the forward price.
Forward Contract Example
- 1A U.S. importer agrees to buy €1 million in 90 days at a forward rate of 1.08 USD/EUR, locking in a total cost of $1,080,000 regardless of future exchange rate moves
- 2A wheat farmer enters a forward contract to sell 50,000 bushels at $6.50/bushel in 6 months, eliminating the risk of falling prices at harvest time
Related Terms
Futures Contract
A standardized exchange-traded agreement to buy or sell an asset at a predetermined price on a specific future date, with daily mark-to-market settlement.
Swap
A derivative contract in which two parties exchange cash flows or financial instruments over a specified period.
Contango
A market condition where futures prices are higher than the current spot price, typically reflecting storage costs, financing costs, and convenience yield.
Backwardation
A market condition where the futures price of a commodity is lower than the current spot price, often signaling tight supply.
Notional Value
The total value of a derivatives position based on the underlying asset's price, representing the full exposure rather than the capital invested.
Call Option
A contract giving the holder the right, but not the obligation, to buy an underlying asset at a specified price within a specified time period.
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