Forward Contract

Forward Contract Glossary Definition

An contract between two parties in which (a) the buyer agrees to pay the seller a sum of money on a future date in exchange for something in return; and (b) the parties reach their agreement without the involvement of a futures exchange or clearinghouse. Like a futures contract, what the buyer receives could be an asset, a currency, an option, or a sum of money representing the value of an asset or currency. But unlike a futures contract, the agreement can contain non-standard terms and conditions, such as unusual quantities or expiration dates. More importantly, each party in a forward contract must agree to assume the credit risk of the other party. Depending on their perceptions of the credit risk, the parties might impose some type of collateral requirements, but they are unlikely to require margins or daily settlements of the type required on futures exchanges. Because of these features, forward contracts are generally not designed to be tradable; there is essentially no secondary market for them.

When first established, a forward contract is neither an asset nor a liability. It is simply an agreement with an initial value of zero, since at the outset neither party pays anything to the other. A forward contract acquires a positive or negative value only after payment is made.

Forward prices are obtained by taking the spot price and adding to it the cost of carry, which is the storage cost and the interest foregone minus any convenience yield or dividend/interest paid on the underlying instrument. This is similar to the way futures are priced. However, there are two major considerations that can lead to price differentials between forwards and futures:

(a) Futures contracts will be marked to market daily, whereas forward contracts will not.

(b) Forward contracts have credit risks that futures contracts do not.

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