What is a Forward Contract?

A forward contract is one of the most fundamental tools in finance — a simple agreement to buy or sell something at a fixed price on a future date. It's the building block from which much of the derivatives world is constructed, and it's widely used to lock in prices and manage risk. This guide explains what a forward contract is, how it works, how it differs from a futures contract, and what it's used for — in clear, plain language. It complements our guides to forward rates and the forward rate agreement, and is relevant to anyone studying derivatives or finance.

What is a forward contract?

A forward contract is a customised agreement between two parties to buy or sell an asset at a specified price on a specified future date. The agreed price is called the forward price, and the future date is the delivery or maturity date. Crucially, a forward is an obligation, not an option: both parties are committed to go through with the trade, whatever the market price turns out to be. Forwards are typically traded over-the-counter (OTC) — privately negotiated between the two parties — which means they can be tailored exactly to the amount, asset and date the parties need.

How a forward contract works

In a forward, one party agrees to buy (the "long" position) and the other to sell (the "short" position) the asset at the forward price on the maturity date. Usually no money changes hands upfront — the contract is settled at maturity. At that point, if the market (spot) price is above the agreed forward price, the buyer benefits (they pay less than the asset is now worth); if the spot price is below the forward price, the seller benefits. The payoff is linear and symmetric: every pound the spot price moves changes the contract's value one-for-one. This locks in certainty for both sides — they know today exactly what price they'll transact at.

A simple example

Suppose a baker knows they'll need to buy wheat in six months and wants to avoid the risk of prices rising. They enter a forward contract to buy wheat in six months at a fixed price of, say, £200 per tonne. If the market price in six months is £230, the baker still pays only £200 — saving £30 and benefiting from the contract. If the market price falls to £180, the baker is still obliged to pay £200, paying £20 more than the spot price. Either way, the baker has achieved what they wanted: certainty. They've removed the risk of price swings, which is the whole point of hedging with a forward.

Forward contracts versus futures

Forwards are closely related to futures contracts, but with important differences. Forwards are OTC, customised, and carry counterparty risk (the danger the other side defaults), and they're usually settled only at maturity. Futures, by contrast, are exchange-traded and standardised, with a clearing house guaranteeing the trade and daily margining (gains and losses settled each day) that largely removes counterparty risk. In short, a forward is the flexible, private cousin; a futures contract is the standardised, exchange-traded version of the same basic idea.

What forward contracts are used for

Forward contracts have two main uses. The first is hedging — locking in a future price to remove uncertainty, as the baker did. Companies use FX forwards to fix exchange rates on future foreign-currency payments, and commodity forwards to fix input costs. The second is speculation — taking a forward position to profit from an expected price move, without needing to own or fund the asset today. Because they're customisable and require little or no upfront cash, forwards are a flexible and widely-used tool across currencies, commodities, interest rates and more.

Frequently asked questions

What is a forward contract?

A customised, over-the-counter agreement between two parties to buy or sell an asset at a fixed price on a future date — an obligation for both sides, not an option.

How does a forward contract work?

One party agrees to buy and the other to sell at the agreed forward price on maturity. Usually no money changes hands upfront; the payoff is linear, benefiting the buyer if the spot price ends above the forward price.

How does a forward differ from a futures contract?

Forwards are OTC, customised, carry counterparty risk and settle at maturity; futures are exchange-traded, standardised, daily-margined and guaranteed by a clearing house.

What are forward contracts used for?

Hedging — locking in a future price to remove uncertainty (e.g. FX or commodity forwards) — and speculation on expected price movements.

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