Introduction to Forward Contracts

A forward contract is an agreement between two parties to buy or sell an underlying asset at a pre-specified price on a pre-specified date in the future. The assets underlying a forward contract could be anything, such as a commodity (gold, oil, cotton, etc.), or financial instruments (equity, T-bills, currencies, etc.).

Forward contracts are private contracts and are traded over-the-counter between two parties. As opposed to a futures contract, they are not exchange traded, and do not have standardized features. Instead they are customized to meet the specific needs of the two parties.

The forward contracts are primarily used as a way of hedging a preexisting risk. The following video from Khan Academy provides a wonderful introduction about how forward contracts work and how they help the different parties in the contract.

The above video takes the example of agriculture products to illustrate how a forward contract works. In the next articles, we will take the example of a financial instrument (T-bill) to illustrate the working of a forward contract and the risks involved.