What Is a Forward Commitment?
A forward commitment is a contractual agreement 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.
- A forward commitment is a binding agreement to carry out a specific transaction at a specified future date.
- Forward commitments are used to reduce uncertainty and risk around the transaction, particularly risk related to price volatility.
- Forward commitments are common in futures markets but are not limited to them.
Understanding a Forward Commitment
Forward commitments enable 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 the 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 the buyer over that same time period. When used to lock in a price, this is known as a forward hedge.
Forward commitments can be traded in the form of derivatives contracts, particularly exchange-traded futures 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 product.
Other Types of Forward Commitment
Forward commitments are closely associated with commodities due to their heavy use in futures markets, but the term generally applies to any arrangement 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 for which there is a time lag between creation and sale, as with a commodity that is extracted or harvested.
A forward commitment is also used with loans. Property builders may enter a forward commitment with a bank to lock in the interest rates and the terms of a loan prior to the loan actually being required for the development. This provides the borrower with the security of knowing they will have the funds when needed while giving the lender the ability to forecast future business more accurately.
Forward Commitment Versus Contingent Claims
Derivatives can contain forward commitments or contingent claims. While a forward commitment contains an obligation to carry out the transaction as planned, 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 affects how the contracts themselves trade.
The value of a derivative with a forward commitment will move more or less in lockstep with the price of the underlying product. In contrast, a contingent claim derivative will increase or decrease with the likelihood of the right being exercised for a profit.