Forward Contract

Forward contracts are non-standardized agreements between two parties, which can be traded on the Over-the-Counter (OTC) market or involve highly-customized private agreements. Also known as forwards, these contracts do not involve margin true-ups, and are not marked-to-market over time. Unlike futures contracts, which are often sold before the expiration date, forward contracts are typically settled between the two parties in either cash or physical delivery of the asset. The non-standard nature of these contracts, lack of true-up, along with a decentralized trading marketplace, increases their risk of default. While forwards can be used for speculative purposes, they are valued by hedgers that want to insulate themselves from future price movements of the underlying asset. The contract between the parties will specify the delivery price, quantities, as well as the settlement date. The party purchasing the asset is said to be taking a long position, while the seller is assuming a short position.

A grain farmer in Oklahoma is worried the price of wheat will decline over the next four months and wants to lock in the profit associated with their crop. The farmer expects to harvest 100,000 bushels of wheat and has signed a forward contract with a large financial institution at a price of $6.70 per bushel in September. The two parties agreed that settlement would be on a cash basis.

Poor weather in Texas drove up the price of wheat to $7.10 per bushel on the contract's expiration date. The farmer was required to pay the large financial institution:

= ($7.10 - $6.70) x 100,000 bushels, or $40,000

Fortunately, the farmer was able to sell their crop on the spot market for $7.10 per bushel, thereby protecting their revenue of $6.70 x 100,000 bushels, or $670,000.