Glossary term
Forward Contract
A forward contract is a private agreement to buy or sell an asset at a set price on a future date.
Updated
Read time
What Is a Forward Contract?
A forward contract is a private agreement to buy or sell an asset at a set price on a future date. The asset could be a commodity, currency, security, or other financial exposure, depending on the contract.
Forward contracts are often used to hedge price risk. A business that expects to receive a foreign currency later, buy a commodity later, or sell a product later may use a forward contract to reduce uncertainty around the future price.
Key Takeaways
- A forward contract sets a future price today.
- Forward contracts are private and customized rather than exchange-standardized.
- They can be used for hedging or speculation.
- Both sides generally take counterparty risk because performance depends on the other party.
- Forward contracts are related to, but different from, futures contracts.
How Forward Contracts Work
Two parties agree on the asset, quantity, price, and settlement date. When the settlement date arrives, the contract is settled according to its terms. If the market price has moved, one party benefits from the fixed contract price and the other gives up that advantage.
That tradeoff is the point. The contract can reduce uncertainty for a hedger, but it can also create loss if the market moves in the opposite direction.
Forward Contract Versus Futures Contract
Feature | Forward contract | Futures contract |
|---|---|---|
Trading venue | Private agreement | Exchange-traded |
Terms | Customized | Standardized |
Credit risk | Counterparty risk can be meaningful | Clearinghouse structure reduces counterparty risk |
Common use | Customized hedge | Hedging, speculation, and trading liquidity |
Why Forward Contracts Matter
Forward contracts can help businesses plan around prices that would otherwise be uncertain. A company importing goods, borrowing in a foreign currency, or buying raw materials may prefer a known future price to an unknown one.
For investors, the main caution is that forwards can behave like leverage. A small change in the underlying price can create a large gain or loss relative to the cash initially exchanged.
The Bottom Line
A forward contract locks in a future price through a private agreement. It can be useful for hedging, but it also carries counterparty, liquidity, and pricing risk that should be understood before entering the contract.