Forward Contract

Loading the player...

What is a 'Forward Contract'

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. Unlike standard futures contracts, a forward contract can be customized to any commodity, amount and delivery date. A forward contract settlement can occur on a cash or delivery basis. Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk. As a result, forward contracts are not as easily available to the retail investor as futures contracts.

BREAKING DOWN 'Forward Contract'

Consider the following example of a forward contract. Assume that an agricultural producer has 2 million bushels of corn to sell six months from now, and is concerned about a potential decline in the price of corn. It therefore enters into a forward contract with its financial institution to sell 2 million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

  1. It is exactly $4.30 per bushel: In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
  2. It is higher than the contract price, say $5 per bushel: The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
  3. It is lower than the contract price, say $3.50 per bushel: The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.

The market for forward contracts is huge, since many of the world’s biggest corporations use it to hedge currency and interest rate risks. However, since the details of forward contracts are restricted to the buyer and seller, and are not known to the general public, the size of this market is difficult to estimate. The large size and unregulated nature of the forward contracts market means that it may be susceptible to a cascading series of defaults in the worst-case scenario. While banks and financial corporations mitigate this risk by being very careful in their choice of counterparty, the possibility of large-scale default does exist.

Another risk that arises from the non-standard nature of forward contracts is that they are only settled on the settlement date, and are not marked-to-market like futures. What if the forward rate specified in the contract diverges widely from the spot rate at the time of settlement? In this case, the financial institution that originated the forward contract is exposed to a greater degree of risk in the event of default or non-settlement by the client than if the contract were marked-to-market regularly.

RELATED TERMS
  1. Forward Exchange Contract

    A special type of foreign currency transaction. Forward contracts ...
  2. Delivery Date

    1. The final date by which the underlying commodity for a futures ...
  3. Seller's Option

    The right of a forward contract seller to choose some of the ...
  4. Cash Contract

    A financial arrangement that requires delivery of a particular ...
  5. Futures

    A financial contract obligating the buyer to purchase an asset ...
  6. Front Month

    Used in futures trading to refer to the contract month with an ...
Related Articles
  1. Term

    The Difference Between Forwards and Futures

    Both forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
  2. Options & Futures

    20 Investments: Futures Contract

    What Is It? As the name implies, futures are contracts on commodities, currencies, and stock market indexes that attempt to predict the value of these securities at some date in the future. ...
  3. Active Trading

    Grow Your Finances In The Grain Markets

    Hedging with futures can protect those who buy and sell commodities from adverse price movements.
  4. Options & Futures

    How to Use Commodity Futures to Hedge

    Both producers and consumers of commodities can use futures to hedge. We explain, using a few examples, how to achieve commodity hedging with futures.
  5. Products and Investments

    Divorce and Annuities: What Clients Need to Know

    Divorce can be the most financially devastating event in a person’s life. Here’s what your clients need to know about handling annuities in a divorce case.
  6. Options & Futures

    Commodities: Corn

    By Noble Drakoln"Corn" is an English word used to describe any type of grain. In many parts of the world, it is known as "maize," which was the name predominately used before grain was discovered ...
  7. Markets

    Crude Oil Prices: Comparing Future Price Vs. Current Market Price

    Discover the differences between oil futures market prices and oil spot market prices and what leads to the differences between the two.
  8. Forex Education

    4 Reasons Currency Hedging is Important

    Learn how currency hedging can help reduce exchange rate risk for a portfolio of foreign stocks. Consider the cost of hedging and its potential benefits.
  9. Forex Education

    Getting Started In Foreign Exchange Futures

    Learn how these futures are used for hedging and speculating, and how they are different from traditional futures.
  10. Options & Futures

    Beginner's Guide To E-Mini Futures Contracts: E-Mini Specifications

    Each e-mini contract has certain specifications as outlined by its host exchange. Ticker SymbolEach contract has a ticker symbol, or an arrangement of letters representing the specific contract. ...
RELATED FAQS
  1. What is the difference between forward and futures contracts?

    Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell ... Read Answer >>
  2. What is the difference between a forward rate and a spot rate?

    Learn about spot and forward contracts, how spot and forward rates are used for spot and forward contracts, and the difference ... Read Answer >>
  3. How are forward contracts regulated in the United States?

    Read about the risks of forward contracts and why they are not readily subject to regulation, including what happens when ... Read Answer >>
  4. What is a forward contract against an export?

    Understand forward exchange contracts in exporting, and learn the purpose of using a forward contract and its advantages ... Read Answer >>
  5. How do the investment risks differ between options and futures?

    Learn what differences exist between futures and options contracts and how each can be used to hedge against investment risk ... Read Answer >>
  6. How can a futures trader exit a position prior to expiration?

    A futures contract is an agreement to buy or sell a commodity at a pre-determined price and quantity at a future date in ... Read Answer >>
Hot Definitions
  1. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  2. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  3. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
  4. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  5. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  6. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
Trading Center