What Is a Forward Commitment?
A forward commitment is a contractual agreement between a buyer and seller to carry out a transaction in the future. A forward commitment will specify the commodity or goods being sold, the price, payment date, and delivery date. Forward commitments are contained within several types of derivatives, including forward contracts, futures contracts, and swaps.
Understanding a Forward Commitment
Forward commitments are a mechanism for two parties to reduce the risks and uncertainties around a planned transaction in the future. For example, a producer of a commodity like wheat knows he must sell his crop at some point after harvest. A futures contract with a forward commitment allows the producer to find a buyer in advance, locking in the sale price for the producer and removing pricing variability for the buyer over that same time period. Forward commitments can, of course, be traded in the form of contracts. So the agreement between the producer and the end customer may end up being traded between parties who have no direct interest in actually taking delivery of the underlying.
Other Types of Forward Commitment
Forward commitments are closely associated with commodities due to the heavy use of futures in this market, but the term applies to a range of financial arrangements in which two parties agree to the terms of a future transaction well in advance of it occurring. Forward commitments can cover the future purchase of financial products or any other asset where two parties want to remove pricing volatility for a set period of time. Usually, a forward commitment is reserved for products where there is a time lag between creation and sale, as with a commodity that is extracted or harvested.
Forward commitment is also used in the context of loans. Property builders may enter a forward commitment with a bank to lock in the interest rates and terms of a loan prior to it being required for the development. This formal arrangement provides the borrower with the security of knowing they will have the funds when needed. For the lender, a forward commitment gives them the ability to forecast future business more accurately.
Forward Commitment vs. Contingent Claims
Derivatives can contain forward commitments or contingent claims. A forward commitment contains an obligation to carry out the transaction as planned, whereas a contingent claim contains the right to carry out the transaction but not the obligation. As a result, the payoff profiles between these derivatives vary, and that impacts how the contracts themselves trade. The value of a derivative with a forward commitment will move more or less in lock step with the price of the underlying. In contrast, a contingent claim derivative will increase or decrease with the likelihood of the right being exercised for a profit.