Forward contract
Also called: Forwards · Topic: Financial Markets, Instruments, Insurance and Pensions · NCERT: Beyond NCERT
Meaning
A forward contract is a private agreement between two parties to buy or sell an asset at a fixed price on a set future date. It is made over the counter (OTC), meaning directly between the two parties and not on an exchange. So its terms, such as quantity, date and price, can be tailored to their needs. Because no clearing house stands in between, each side carries counterparty risk: the risk that the other side fails to honour the deal. Forwards are widely used for hedging, which means protecting against price changes.
Example
An Indian exporter expects to receive dollars in three months. It agrees with its bank today to sell those dollars at a fixed rupee rate. This protects the exporter if the rupee rises (strengthens) before the dollars arrive.
Don't confuse with
- Futures: these are standardised forwards traded on an exchange. They are settled daily at market prices (mark-to-market) and backed by margins, and the clearing corporation removes counterparty risk. Forwards are customised and carry counterparty risk.
Related concepts
- Derivatives
- Futures
- Options
- Swap
- Interest rate swap
- Credit default swap
- Commodity derivatives
- Hedging
- Arbitrage
- Futures and options trading