Finance Theory

Forward Contracts

Definition:  A forward contract is a commitment to purchase at a future  date a given amount of a commodity or an asset at a price agreed on today.


  • The price fixed now for future exchange is the forward price
  • The buyer of the underlying is said to be "long" the forward

Features of Forward Contracts

  • Customized
  • Non-standard and traded over the counter (not on exchanges)
  • No money changes hands until maturity
  • Non-trivial counter party risk

Example:

  • Current price of soybeans is $160/ton
  • Tofu manufacturer needs 1,000 tons in 3 months
  • Wants to make sure that 1,000 tons will be available
  • 3-month forward contract for 1,000 tons of soybeans at $165/ton
  • Long side will buy 1,000 tons from short side at $165/ton in 3 months