Forward contract
Family I · Instruments
Not to be confused with futures contract, contract size, contract specification.
Forward contract is an over-the-counter derivative in which two parties agree today on a price and a future settlement date for an asset. Unlike exchange-traded instruments, its size, delivery terms and credit arrangements are customised between the counterparties. Settlement may be by physical delivery or by cash payment of the difference between the agreed price and a reference price.
Core mechanics
A forward contract fixes a price, called the forward price, for an asset that will change hands on a stated future date. No money changes hands at inception in a standard non-collateralised forward; the contract has zero initial value to both sides apart from any credit adjustment. At maturity the buyer pays the agreed price and receives the asset, or the two sides exchange the net cash difference.
Because the contract is bilateral, each party bears the other's default risk. Terms such as the quantity, quality, delivery location and settlement method are negotiable, and the contract is not standardised or cleared through a central counterparty unless the parties separately agree to that.
Worked example
An airline agrees a forward contract with a fuel supplier to buy 100,000 barrels of jet fuel in six months at a fixed price of $85 per barrel.
If the reference price had instead been $80, the buyer would pay the supplier $500,000. Physical delivery would replace the cash difference with the transfer of the fuel itself.
Where forwards are used
Forwards appear wherever a party needs to lock in a future price or exchange rate. Common uses include:
- Corporates hedging foreign-currency receivables or payables.
- Producers and consumers of commodities fixing input or output prices.
- Financial institutions managing interest-rate exposure through forward rate agreements.
- Investors taking directional positions without using a listed market.
Because forwards are not exchange-traded, position sizes and maturities can be tailored, but liquidity is generally lower and closing a position before maturity usually requires the counterparty's consent or a separate offsetting contract.
Often confused with
- futures contract
- A futures contract is standardised and traded on an exchange with daily margin and central clearing, whereas a forward contract is privately negotiated and bilateral; the visible sign is that futures prices and volumes are publicly quoted while forward terms are not.
- contract size
- Contract size is the quantity of the underlying asset represented by one contract, not the agreement itself; the visible sign is that contract size is a number of units, while a forward contract is the legal agreement specifying a price and date.
- contract specification
- A contract specification is the document listing the standard terms of an exchange-traded contract, whereas a forward contract is the bilateral agreement whose terms are individually negotiated; the visible sign is that a specification is a published standard, while a forward's terms are private.