What is a forward contract, and who actually uses one?
Strip away every piece of jargon and a forward is the oldest deal in commerce: we agree today on a price, and we settle the trade on a date in the future. No money changes hands now. The price is fixed now. The goods — or the cash — move later.
A miller and a farmer shake hands in June: 50,000 bushels of corn, $4.60 a bushel, delivered in November. Whatever corn is worth that November — $3.00, $6.00, anything — that handshake says $4.60. Both sides have swapped uncertainty for certainty, on purpose.
The four things a forward fixes
- Underlying — what, precisely. Not "corn" but a grade of corn.
- Quantity — how much.
- Price — the number agreed today.
- Date (and place) — when and where it settles.
Everything else about the contract is negotiable, because the whole thing is negotiated. Forwards trade over the counter (OTC) — privately, party to party, with no exchange in the middle.
Bespoke is a feature and a bug
The feature is obvious: you get exactly the deal you need. A miller who needs 47,300 bushels delivered to one specific silo on 14 November can have precisely that. No rounding, no compromise on dates.
The bugs are less obvious and much larger.
Illiquidity. There is no secondary market for your one-off contract. You cannot sell it on. If you change your mind, your options are to negotiate a cancellation with the person on the other side — who knows perfectly well that you are stuck — or to strike an offsetting forward with a third party and manage two contracts instead of one.
Counterparty risk. This is the big one. The entire value of a forward is a promise. Suppose November arrives and corn is $3.00. The farmer, who agreed to sell at $4.60, is holding a winner worth $1.60 a bushel — $80,000 on 50,000 bushels. That $80,000 exists only if the miller actually pays. A forward is a credit exposure dressed up as a price agreement, and the exposure grows precisely as the contract becomes more valuable to you.
No daily truth-telling. In the classic uncollateralised forward, nothing marks the contract to market and nobody posts collateral as it moves. The loss builds silently across five months and then arrives all at once, in full, on delivery day — at the exact moment the losing side is least able to absorb it.
Forwards are not a museum piece
It would be tidy to say exchanges replaced forwards. They did not. The FX forward market is one of the largest markets on earth — banks quote forward exchange rates as routinely as spot, and corporates use them to fix the rate on a payment due in nine months. Forward rate agreements do the same job for interest rates. Wherever the customisation matters more than the liquidity, and the counterparty is creditworthy, forwards survive.
What changed is that a second, standardised version appeared alongside them — and it took over the markets where anonymity, liquidity and safety mattered more than tailoring. That is the next lesson.
Try it now
- A year of corn is below, in cents per bushel. Pick a date roughly five months back and read the price there.
- Treat that day's price as a forward struck then. Measure from it to today, and convert the gap into dollars on a 50,000-bushel deal — ten contracts' worth.
- Say out loud who ended up exposed to whom, and how big that credit exposure got. That number — the one you just computed, owed by somebody with no daily settlement behind them — is what the clearing house was invented to abolish.