What exactly is a forward contract?
A forward is the simplest derivative there is, and every other family is a variation on it. Four terms define one completely:
- the underlying — what is being bought and sold;
- the quantity — how much;
- the forward price — the price agreed today;
- the date — when it happens.
Add the two signatures and you have the entire instrument. Both sides are obliged: there is no walking away.
A worked case from real corporate life
A German manufacturer ships machinery to a US buyer and will be paid $1,200,000 in 90 days. Today EUR/USD is 1.10, so that invoice is worth:
$1,200,000 ÷ 1.10 = €1,090,909
That is the number in the budget. But the company will not receive euros for 90 days, and the rate will move. If EUR/USD goes to 1.20:
$1,200,000 ÷ 1.20 = €1,000,000
The company just lost €90,909 — about 8% of the sale — for reasons entirely unrelated to machinery. It did not take a currency view; it simply sold something abroad, and a currency position arrived attached.
So it enters a 90-day forward to sell $1,200,000 at, say, 1.105, fixing €1,085,973. Whatever EUR/USD does, that is the number that lands.
Note the shape carefully, because it is easy to misread. The forward does not sit below the spot calculation because certainty carries a price tag. The gap is the interest-rate differential between the two currencies over those 90 days — the carry arithmetic set out below, and nothing else. Reverse which currency pays the higher rate and the forward would fix more than the spot calculation, with the economics of hedging entirely unchanged. What the company actually gave up is the good outcome: had EUR/USD fallen to 1.05, the market would have paid $1,200,000 ÷ 1.05 = €1,142,857, and the forward surrenders €56,884 of that. Certainty runs in both directions — the €90,909 loss is gone, and so is the matching gain. That is what hedging is.
What "bespoke" buys and what it costs
The forward was written for $1,200,000 on the exact day the invoice settles. Not $1,000,000 on the third Wednesday of the month — the actual amount, the actual date. That precision is the great advantage of a forward, and it is why the foreign-exchange and interest-rate forward markets are enormous despite exchanges existing.
The cost is that the contract is welded to one counterparty. There is no market for a contract that fits nobody else. To exit early you must negotiate with that same bank, or write a second contract that offsets the first and carry both. And if the bank fails in month two, your hedge fails with it — the subject of Unit 3.
The forward price is not a forecast
This one misconception causes more confusion than any other. A one-year forward price of $105 on a $100 share is not the market's prediction of next year's price. It is arithmetic:
Forward ≈ Spot + cost of carry (financing cost, plus storage where relevant, minus any income the asset pays)
A share at $100, one-year financing at 5%, no dividend, gives a fair forward of about $105. Suppose someone quoted $110 instead. Then anyone could: borrow $100, buy the share, sell the forward at $110, deliver the share in a year, repay $105, and keep $5 with no market risk taken. That trade would be done until the price fell back. The forward price is pinned by the ability to do it, not by anybody's opinion.
Understanding this immunises you against a whole genre of bad market commentary that reads forward and futures prices as forecasts.
Try it now
- Five years of EUR/USD is below. Find the largest move across any 90-day window on it and Measure it with the chart's tool.
- Apply that move to a hypothetical $1,200,000 invoice and compute the euro difference. That is the size of the exposure a forward would have removed — in both directions.
- Each currency's short rate is below: the Fed's target range and the ECB's three rates, on the same day. Take the Fed's upper bound and the ECB's deposit rate and write the gap in percentage points. That gap is roughly what pushes a currency forward price above or below spot. Not a forecast — a carry calculation.