September 19, 2025
4 mins read
I first made sense of forward contracts when I thought of them as something similar to fixing a cab fare before the journey even begins. You agree on a price today for a transaction that will take place at a future date, regardless of how the market behaves in the meantime.
These contracts are often used in two ways: hedgers rely on them to protect against sudden price changes, while speculators use them to try and benefit from expected movements. The principle is straightforward — fix a price now, settle later. This arrangement is common in markets for commodities, currencies, and other assets where prices tend to fluctuate frequently.
Like planning a trip with a friend – You both agree on the destination, budget, and date months in advance. No matter what happens later, those terms stay.
One to buy, one to sell – The buyer and seller fix the price and date ahead of time.
No exchange in the middle – This is a private agreement shaped by the two parties, not exchange rules.
Different reasons for using it – Some use it to shield themselves from unpredictable prices (I once did this for coffee beans in my café days), others use it to make a calculated bet on the market.
Payment and delivery later – Nothing changes hands until the agreed date arrives.
Here are the critical features of forward contracts:
A forward contract involves only two parties, without the role of an intermediary. The buyer and seller directly enter into an agreement.
Forward contracts are customisable. These are not standardised contracts and are not traded on any Exchange.
The parties entering the contract have opposing views on the underlying asset price.
There are two ways by which the parties can settle the contract. The first is to take physical delivery, and the second is through a cash settlement.
Forward contracts do not require any margin amount and are easier to trade.
When I used to run a small café stall at weekend markets, the price of coffee beans was my huge concern. Every festive season, the rates would climb, and I would either have to swallow the cost or nudge my prices up.
One year, I decided to make a deal with a supplier: a fixed price for the next three months, no matter what happened in the market. I still remember feeling oddly calm after that — for once, I could plan my menu without worrying about sudden price hikes.
In this case, the buyer was right. Even though the prices increase, the buyer can purchase the asset at the predetermined price. The seller, however, experiences a loss.
As prices increased, the seller would have made more substantial profits by selling the same asset for a higher price. However, by entering into the forward contract, the seller must fulfil the contract by selling sell the asset at the price determined in the forward contract.
If the buyer or seller were to make a transaction on the specific asset without the contract, the asset price would still be the same. Therefore, in this case, the buyer and seller each do not make any profit or loss.
In such a scenario, the seller makes a profit. Although the asset price falls, the buyer is still obligated to purchase the asset at the predetermined price, which would be higher than the current market price. Therefore, in this scenario, the buyer suffers a loss while the seller experiences a profit.
Feature | Forward Contract | Future Contract |
Nature | Private agreement between two parties | Standardised contract traded on an exchange |
Customisation | Fully customisable terms, amount, and date | Fixed terms set by the exchange |
Regulation | Not regulated by exchanges; carries counterparty risk | Regulated by exchanges; lower default risk |
Settlement | Happens on the agreed future date | Can be settled daily through mark-to-market |
Liquidity | Less liquid, depends on finding a counterparty | Highly liquid due to active trading on exchanges |
Use | Often used for hedging specific needs | Used for both hedging and speculation in standardised markets |
Traders frequently use forward derivatives to protect themselves against adverse price movements or to speculate for potential profit. These contracts are highly customizable, allowing parties to agree on specific quantities, prices, and settlement dates according to their requirements.
Unlike standardized futures contracts, forwards are not traded on exchanges, which makes them flexible but also exposes participants to additional risks. Since these contracts are over-the-counter and unregulated, there is a possibility of default by one of the parties, as well as counterparty risk. Proper risk management and due diligence are essential when engaging in forward derivative transactions.
Forward contracts are customizable and traded over-the-counter (OTC), while futures contracts are standardized and traded on exchanges, offering greater liquidity and regulatory oversight
Advantages include customization to specific needs, flexibility in terms, and the ability to hedge against price fluctuations without initial costs
Risks include counterparty default, lack of liquidity, and potential for significant losses due to market volatility, as these contracts are not regulated
Businesses and financial institutions use forward contracts to hedge against risks in currencies, commodities, or interest rates, ensuring price stability and financial planning
Yes, investors can use forward contracts to speculate on price movements of assets, aiming for profit, though this involves higher risk due to market uncertainties
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