Forward Contract

A forward contract is a private agreement between two parties (typically facilitated by a bank) to buy or sell an underlying asset at a fixed price on a specified future date. Unlike standardized futures contracts, forwards are customizable (any quantity, date, asset). They are settled only at maturity (no daily mark-to-market) and carry counterparty risk. Forwards are used extensively in currency and commodity markets by companies hedging operational exposure.

How forwards work

You and a bank agree: “On June 30 (T), I will pay you $1.20 per EUR and receive €1 million in exchange.” This is a forward contract.

The forward price ($1.20) is fixed today, based on the spot price (current EUR/USD rate) and the cost-of-carry (interest rates). The contract obligates both parties; neither has the option to walk away.

At maturity, you settle. If EUR/USD has risen to $1.25, the bank gained $50,000 (you pay $1.20 but the bank could have sold at $1.25). If EUR/USD fell to $1.15, you gained $50,000 and the bank lost. One party wins; the other loses.

Forwards vs. futures

Futures are the exchange-traded standardized version of forwards. Forwards are the bespoke bilateral version.

Pricing: cost-of-carry

The forward price is:

Forward Price = Spot Price × e^(r×T)

For a currency forward with spot EUR/USD = 1.10, US rate = 2%, euro rate = 3%, and T = 1 year:

Forward = 1.10 × e^((0.02-0.03)×1) = 1.10 × e^(−0.01) ≈ 1.089

The forward adjusts for interest-rate differentials, storing the cost-of-carry between the two currencies.

For commodities, cost-of-carry includes storage, insurance, and convenience yield.

Uses and examples

Currency hedges: An exporter earning €1M in 6 months locks in the exchange rate using a 6-month EUR/USD forward, eliminating currency risk.

Commodity locks: A utility fixes the price of heating oil for winter, avoiding price spikes.

Interest-rate forwards: A borrower locks in a future borrowing rate using a forward-rate agreement (FRA).

Counterparty risk

The major risk in forwards is counterparty risk: if the market moves far against the counterparty, they may default rather than settle. After the 2008 crisis, standardized contracts and clearing houses were mandated for many derivatives to reduce this risk.

No mark-to-market

Unlike futures, forwards do not settle daily. Profits and losses are deferred to maturity. This can be good (no forced margin calls) or bad (uncertainty accumulates).

An exporter with a short forward (locked in a sale price) does not receive daily payments if the currency rises; they wait until maturity and settle.

See also