Forward contract

n finance, a forward contract or simply a forward is a non-standardized contract between two parties to
buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot
contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward
contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the
party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called
the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument
changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where
the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at
which the asset changes hands on the spot date. The difference between the spot and the forward price
is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the
purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate
risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying
instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very
similar to futures contracts, except they are not exchange-traded, or defined on standardized assets.
Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like
futures - such that the parties do not exchange additional property securing the party at gain and the
entire unrealized gain or loss builds up while the contract is open. However, being traded OTC, forward
contracts specification can be customized and may include mark-to-market and daily margining. Hence,
a forward contract arrangement might call for the loss party to pledge collateral or additional collateral
to better secure the party at gain.
Payoffs

The value of a forward position at maturity depends on the relationship between the delivery price (K)
and the underlying price (ST) at that time.

 For a long position this payoff is: fT = ST − K

 For a short position, it is: fT = K − ST

How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently
owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward
contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000
(more below on why the sale price should be this amount). Andy and Bob have entered into a forward
contract. Bob, because he is buying the underlying, is said to have entered a long forward contract.
Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then,
because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why
this is so, one needs only to recognize that Bob can buy from Andy for $104,000 and immediately sell to
the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential
loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a forward contract to buy
or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not
wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between
U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which
the contract is closed or the expiration date, one party gains and the counterparty loses as one currency
strengthens against the other. Sometimes, the buy forward is opened because the investor will actually
need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian
dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor
because they are hedging currency risk, but because they are speculating on the currency, expecting the
exchange rate to move favorably to generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100
million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these two amounts
are called the notional amount(s)). While the notional amount or reference amount may be a large
number, the cost or margin requirement to command or open such a contract is considerably less than
that amount, which refers to the leverage created, which is typical in derivative contracts.

Example of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and
that Bob enters into a forward contract to buy the house one year from today. But since Andy knows
that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be
compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one
year is 4%. Then the money in the bank would grow to $104,000, risk free. So Andy would want at least
$104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be
covered.