Forward Contract

AAA

DEFINITION of 'Forward Contract'

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.

INVESTOPEDIA EXPLAINS '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. Currency Forward

    A binding contract in the foreign exchange market that locks ...
  2. Synthetic Forward Contract

    A position in which the investor is long a call option and short ...
  3. Short Date Forward

    A forward exchange contract involving two parties that agree ...
  4. Commodity

    1. A basic good used in commerce that is interchangeable with ...
  5. Cash Market

    The marketplace for immediate settlement of transactions involving ...
  6. Forward Price

    The predetermined delivery price for an underlying commodity, ...
RELATED FAQS
  1. Why do companies use reverse/forward stock splits?

    Companies will use reverse/forward stock splits mainly in an attempt to save future administrative costs. A reverse/forward ...
  2. If a company moves its dividend record date forward, does the ex-dividend date change ...

    When a dividend is declared, there are three important dates for investors: the dividend payable date, the dividend date ...
  3. 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 ...
Related Articles
  1. Home & Auto

    Insure Your Future With A Career As An Actuary

    If you've got excellent math skills, they can add up to a lucrative career as an actuary.
  2. Options & Futures

    Why Forward Contracts Are The Foundation Of All Derivatives

    This article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
  3. Investing Basics

    Differences Between Forward P/E And Trailing P/E

    The most common types of price to earnings ratios are forward P/E and trailing P/E. Find out how they differ and the advantages and drawbacks of each.
  4. Options & Futures

    An Introduction To Managed Futures

    Their inverse correlation with stocks and bonds make these alternative investments worth getting to know.
  5. Options & Futures

    Variable Prepaid Forward Contract: Scam Or Safety Net?

    Top executives can benefit from this kind of contract, but is it at the expense of the shareholders?
  6. Insurance

    Futures Fundamentals

    For those who are new to futures but want a solid understanding of them, this tutorial explains what futures contracts are, how they work and why investors use them.
  7. Forex Education

    Forex Tutorial: The Forex Market

    In this online tutorial, beginners and experts alike can learn the ins and outs of the retail forex market.
  8. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  9. Investing Basics

    A Fresh Look At The Financial Markets

    Different markets provide unique opportunities and risks for investors. Find out more here.
  10. Fundamental Analysis

    Derivatives 101

    Learn how to use this type of investment as an alternative way to participate in the market.

You May Also Like

Hot Definitions
  1. Subsidy

    A benefit given by the government to groups or individuals usually in the form of a cash payment or tax reduction. The subsidy ...
  2. Sunk Cost

    A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business ...
  3. Technical Skills

    1. The knowledge and abilities needed to accomplish mathematical, engineering, scientific or computer-related duties, as ...
  4. Prepaid Expense

    A type of asset that arises on a balance sheet as a result of business making payments for goods and services to be received ...
  5. Gordon Growth Model

    A model for determining the intrinsic value of a stock, based on a future series of dividends that grow at a constant rate. ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center