Forward contracts are an agreement between a buyer and a seller of a certain asset, such as a commodity or financial instrument. The transaction is agreed upon for a predetermined price to be executed at a future date, known as the expiration or delivery date of the contract. This is when either the underlying asset in a forward contract must be delivered or the contract must instead be settled for a cash price.
When forward contracts are traded, no money or asset is exchanged at first. Delivery is reserved for the contract's expiration date. The contract serves as a promise between a buyer and seller to exchange goods at a future date, and it carries with it benefits and risks.
For the seller, a benefit of trading forward contracts is that it relatively removes uncertainty that an asset will be unloaded at what appears to be a reasonable price. In the event that an asset is selling for more money in the open market than the agreed upon price in a forward contract at the delivery date, the seller will attempt to mitigate his losses. One way to do this is to settle the contract for cash instead of following through with delivery on the item.
A benefit for the buyer in a forward contract is that he is relatively guaranteed a price for an asset. As a result, he subsequently can plan his budget accordingly. By locking in a predetermined price, a buyer also is hedging or safeguarding against the possibility of volatility in the underlying asset's price.
Value in a forward contract is derived from an underlying asset, including energy and agricultural commodities, as well as financial instruments. Underlying securities in a forward contract might be volatile commodities, including oil and gas resources. A transportation company, such as an airline or trucking company, might purchase oil and gas forward contracts to ensure that the price of oil or gas will not exceed a certain threshold in coming months.
Components in forward contracts resemble those in a futures contract in terms of the predetermined price and future settlement date, although there are other key differences. Futures contracts are exchanged or traded in organized exchanges, such as the CME Group in the United States or LIFFE in Europe. Forward contracts, on the other hand, are traded in the over-the-counter (OTC) market. The parties involved in forward contracts have more flexibility than futures traders because futures contracts are standardized, and forward contracts can be individually tailored for both parties.
There is increased risk in trading forward contracts versus futures contracts, however. That is because a trade in the futures markets is highly regulated. If either party defaults on an agreement, the trade is guaranteed by a clearing firm. In the OTC markets, however, where forward contracts trade, there is additional counterparty risk. If one party defaults and is unable to deliver an asset or cash, the counter party to that trade is likely to experience a loss.