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:
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.