Forward contract

A Forward Contract is a way for a buyer or a seller to lock in a purchasing or selling price for an asset, with the transaction set to occur in the future. In essence, it is a financial contract obligating the buyer to buy, and the seller to sell a given asset at a predetermined price and date in the future.

A Forward Contract is a cash market transaction in which a seller agrees to deliver a specific cash commodity to a buyer at some point in the future.

Unlike futures contracts, cash forward contracts are privately negotiated and are not standardized. Further, the two parties must bear each other's credit risk, which is not the case with a futures contract.

Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forward contracts trade over the counter (OTC), thus the terms of the deal can be customized to fit the needs of both the buyer and the seller.

What are the uses of forward contracts?

Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost.
This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of a scarce resources. Speculators also use forward contracts to make bets on price movements of the underlying asset. Many corporations and banks will use forward contracts to hedge price risk by eliminating uncertainty about prices.

How do forward contracts work?

Forward contracts have a buyer and a seller, who agree upon a price, quantity, and date in the future in which to exchange an asset. On the delivery date, the buyer pays the seller the agreed upon price and receives the agreed upon quantity of the asset. If the contract is cash settled, the buyer would have a cash gain (and the seller a cash loss) if the spot price, or price of the asset at expiry, is higher than the agreed upon Forward price. If the spot price is lower than the Forward price at expiry, the seller has a cash gain and the buyer a cash loss. In cash settled forward contracts, both parties agree to simply pay the profit or loss of the contract, rather than physically exchanging the asset.

COMPARISON
Trade on organized exchanges Use standardized contract terms Use associate clearinghouses to guarantee contract fulfillment Require margin payments and daily settlements Close easily

FORWARD
No No No

FUTURES
Yes Yes Yes

No

Yes

No

Yes

Regulated by identifiable agencies

Any quantity Any product

No
Yes Yes

Yes
No No