NISM VIII — Equity Derivatives ~5 min read

Forward Contracts

A forward contract is a bilateral, customised, over-the-counter agreement to buy or sell an underlying asset at a specified future date for a price fixed today....

Definition

Forward Contract

A forward contract is a bilateral, customised, over-the-counter agreement to buy or sell an underlying asset at a specified future date for a price fixed today. Both parties are irrevocably bound — regardless of the market price on the settlement date.

In Simple Words

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Forwards are the oldest and simplest derivative. They are privately negotiated, so every term (underlying, quantity, quality, delivery date, settlement location, price) is customised. That flexibility is their biggest strength (for bespoke hedging) and biggest weakness (illiquid, credit-risky, hard to exit). There is no daily mark-to-market; the entire P&L settles on the delivery date. A forward has four key limitations: (i) counterparty risk, (ii) lack of centralisation, (iii) illiquidity — customised contracts have no natural buyer to transfer to, (iv) difficulty in price discovery. These limitations are exactly why exchanges invented futures contracts in 1865 at the Chicago Board of Trade.

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Hand-Shake Deal

Custom contract between two specific parties

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Single Settlement

No daily MTM — all P&L crystallises at maturity

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Tailor-Made

Perfect size match to the underlying hedge

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Counterparty Risk

If they default, you have no clearing corp to fall back on

Real-Life Scenario

A Practical Example

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Scenario

Real-Life Scenario

A coffee exporter in Karnataka signs a forward with a Germany-based buyer on 1 Jan to deliver 100 tonnes of Arabica coffee on 1 Oct at $4,200/tonne. On 1 Oct spot trades at $5,000/tonne. The exporter still must deliver at $4,200 — he "loses" $80,000 vs the open market but he has a locked predictable cash flow ($420,000) — which is the entire point of hedging. If spot had fallen to $3,000, he would be "winning" on the forward, and the buyer would be painfully committed.

Key Points to Remember

What Makes This Important

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Bilateral + customised + OTC — every term negotiable

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No daily MTM — one-shot settlement at maturity

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Both parties are irrevocably bound ("commitment" contract)

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Main use-case: bespoke hedging by corporates and institutions

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Four limitations: counterparty risk, no centralisation, illiquidity, poor price discovery

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Exchange-traded futures were invented to overcome these limitations

FAQs

Frequently Asked Questions

No — a forward is a private, OTC, customised contract with settlement only at maturity. A futures contract is its standardised, exchange-traded, daily-MTM, clearing-corp-cleared cousin. Economically they point at the same exposure; operationally they are very different.

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