Forward Contract: How to Use It, Risks, and Example

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A forward contract is a private agreement between two parties to buy or sell a specific asset at a price fixed today, for delivery or settlement on a set future date. Neither side pays anything upfront in a standard forward. Both are bound: the buyer (long) must buy and the seller (short) must sell at the agreed price, whatever the market does in the meantime. Forwards trade over the counter (OTC) rather than on an exchange, so their terms can be tailored, and each side carries the risk that the other fails to pay.

How a forward contract works

A forward has a few defined terms:

• Underlying asset: a currency, commodity (grain, metals, oil, natural gas, livestock), share, index or bond.
• Notional amount: how much of the asset changes hands.
• Forward price (delivery price): the agreed price per unit.
• Maturity date: when the exchange or cash settlement happens.
• Settlement method: physical delivery of the asset, or a cash payment of the difference between the forward price and the spot price at maturity.

At maturity, the payoff to the long side is:

Long payoff = (Spot price at maturity − Forward price) × Quantity

The short side’s payoff is the same amount with the opposite sign. Forwards are zero-sum between the two parties.

How the forward price is set

The forward price is not a forecast of where the market will go. It comes from the spot price adjusted for the cost of carry: what it costs, or earns, to hold the asset until the delivery date. For a non-dividend asset with continuous compounding, F = S × e^(rT), where S is spot, r is the risk-free rate and T is time in years.

In currencies, the forward rate reflects the interest rate gap between the two currencies (covered interest rate parity). Using simple interest:

F = S × (1 + i_quote × T) / (1 + i_base × T)

The currency with the higher interest rate trades at a forward discount, and the one with the lower rate trades at a forward premium. The difference between the spot and forward rate is quoted as forward points.

Example of a forward contract

Hypothetical example for illustration only. A US importer owes a European supplier €1,000,000 in 90 days and wants to remove exchange rate risk. Assume:

• EUR/USD spot: 1.1000
• USD interest rate: 5% per year; EUR rate: 3% per year
• 90-day period counted as 90/360 = 0.25 years, simple interest, no bank spread

Forward rate = 1.1000 × (1 + 0.05 × 0.25) / (1 + 0.03 × 0.25) = 1.1000 × 1.0125 / 1.0075 ≈ 1.1055

The importer agrees to buy €1,000,000 at 1.1055 in 90 days, a cost of about $1,105,459. At maturity there are three possible cases:

1. Spot is 1.1055. The hedge makes no difference. The importer pays the same as it would have at spot.
2. Spot rises to 1.1500. Unhedged, euros would cost $1,150,000. The forward saves about $44,541, the gain on the long position.
3. Spot falls to 1.0600. Euros would cost $1,060,000 at spot, but the importer still pays $1,105,459, a loss of about $45,459 against spot.

In every case the importer’s cost is fixed. The forward gives up the chance of a better rate in exchange for a known one. If the contract were cash-settled, the importer would buy euros at spot and receive or pay the difference from the bank, which produces the same net cost.

Why companies use forwards

Exporters, importers and borrowers use forwards to lock in costs or revenues so budgets and margins do not depend on future rates. Farmers and commodity buyers use them to fix selling or purchase prices before harvest or delivery. Banks are the usual counterparty.

Forwards can also be used to speculate on a price move. With no initial outlay, a speculative forward is effectively leveraged: a small move in the underlying produces a gain or loss on the full notional.

Risks and limitations

• Counterparty (default) risk. No clearinghouse guarantees performance, so if one party cannot pay at maturity, the other may lose the gain it was owed. Banks vet counterparties and sometimes require collateral, but large, concentrated exposures can still spread one failure’s losses to others.
• Settlement-date risk. Value accumulates until maturity, so the wider the gap between the forward price and the spot price, the larger the single payment due and the higher the chance it is not made.
• Illiquidity. A forward cannot be sold on an exchange. Exiting early means entering an offsetting forward, often with the same bank, or negotiating a termination. Either way, it locks in the gain or loss accrued so far.
• Limited access. Custom OTC terms and credit checks make forwards mainly a tool for businesses and institutions rather than retail traders.

Forward contract vs. similar instruments

Futures are the exchange-traded version of the same idea, with margin and daily settlement reducing default risk. Options cost a premium but let the buyer walk away if the price moves the wrong way. A forward rate agreement (FRA) is a cash-settled forward on an interest rate, not on an asset. A firm purchase contract for physical goods at a set future price works much like a forward, though whether it counts as a derivative for accounting purposes depends on the applicable rules.

FAQs

The Bottom Line

Forwards matter most to importers, exporters, borrowers, farmers and commodity buyers who need a known future cost or revenue. They lock in a rate and give up any better one, so they suit businesses that value budget certainty. Before using one, a firm should weigh the counterparty risk, the difficulty of exiting early and the leverage built into a contract with no initial outlay.