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.

VIDEO

Loading the player...
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. Cash Market

    The marketplace for immediate settlement of transactions involving ...
  5. Commodity

    1. A basic good used in commerce that is interchangeable with ...
  6. Forward Price

    The predetermined delivery price for an underlying commodity, ...
RELATED FAQS
  1. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  2. What is a forward contract against an export?

    A forward contract against an export is an agreement between the importer and exporter to exchange a specified amount of ... Read Full Answer >>
  3. What kinds of derivatives are types of forward commitments?

    A derivative is a type of security in which the price of the security is dependent on underlying assets. A derivative could ... Read Full Answer >>
  4. How is a share premium account taxed?

    The two main differences between a spot rate and a forward rate are the timing of delivery of a commodity, security or currency ... Read Full Answer >>
  5. 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 ... Read Full Answer >>
  6. 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 ... Read Full Answer >>
  7. 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 Full Answer >>
Related Articles
  1. Investing Basics

    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.
  2. 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.
  3. 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 ...
  4. 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.
  5. Options & Futures

    An Introduction To Managed Futures

    Their inverse correlation with stocks and bonds make these alternative investments worth getting to know.
  6. 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?
  7. 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.
  8. 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.
  9. Fundamental Analysis

    What is a Forward Rate?

    Forward rate is used in both bond and currency trading to represent the current expectations of future bond interest rates or currency exchange rates.
  10. Investing Basics

    Understanding Non-Deliverable Forward (NDF)

    A foreign exchange hedging strategy where the parties agree to settle the profit or loss in a foreign currency futures contract before the expiration date.

You May Also Like

Hot Definitions
  1. Topless Meeting

    A meeting in which participants are not allowed to use laptops. A topless meeting organizer can also ban the use of smartphones, ...
  2. Hedging Transaction

    A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. Hedging ...
  3. Bogey

    A buzzword that refers to a benchmark used to evaluate a fund's performance. The benchmark is an index that reflects the ...
  4. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
  5. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  6. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!