What is forward contracts and it’s types | Explain the difference between forward and future contracts with example

Have you ever wanted to see what the future holds and secure a good deal? That is essentially what a forward contract allows you to do! Forward contracts are like a time machine that allows two parties to agree today on a price to buy or sell something in the future. Forward contracts are very useful tools to hedge risk, especially with currencies and commodities.

What Are Forward Contracts?

A forward contract is a basic yet effective financial arrangement involving the agreement of two parties to buy or sell a specified asset for a predetermined price at a specified time in the future. You can think of a forward contract as a customized transaction that you can lock in today for a transaction in the future. As an example, a farmer can agree to a set price for the wheat crop he will harvest in the future, guaranteeing his income regardless of whether prices drop in the future. A business also can enter into a forward contract to lock in the exchange rate if it will need to make a foreign currency payment in the future. While the parties to a forward contract enjoy flexibility since the details of the agreement are private, there is still the risk of a counterparty that does not fulfill its obligations under the contract.

Key characteristics:

• Binding obligation: Both parties must fulfill the contract at maturity, either through physical delivery or cash settlement.
• No upfront cost: Typically, no premium is paid initially; profits or losses are realized at settlement.
• Counterparty risk: Since there’s no intermediary, there’s a risk that one party defaults.
• Customization: Terms like quantity, quality, delivery location, and date can be tailored to the parties’ needs.

Types of Forward Contracts

Currency Forwards (FX Forwards):

A currency forward, known as an FX forward, is a private agreement between two parties, such as a bank and a company, to exchange an agreed-upon amount of one currency for another currency at a pre-determined rate of exchange at a future date. A forward works like locking in today’s exchange rate for a payment you know you will need to make in the future, say in 30, 90, or 180 days. It’s important to emphasize that this is a risk management tool, not for speculation. For example, if a US company must pay a European supplier €1 million in three months, the US company can execute an FX forward to lock in what the exact dollar cost will be today. This means they are fully shielded from the risk that the euro could rise in relation to the dollar over that time. While the currency forward gives the company certainty about the payment and additional protection against risk, the US company also gives up any potential gain in the event that the exchange rate transacts in its favor.

• A U.S. importer agrees to buy €100,000 from a European supplier at an exchange rate of 1.10 USD/EUR in three months.

Cash-Settled Forwards (Non-Deliverable Forwards – NDFs):

You can think of a Non-Deliverable Forward (NDF) as a unique kind of agreement related to currencies that are difficult to deal with, for example, the Indian Rupee. Instead of exchanging the actual currency, it is settled in cash, typically USD. On the settlement date, you look at your locked-in price and compare it to the market price of the currency, then if your price was better, the other side pays you the difference; if it was worse, you communicate to that party and you pay them the difference. This is a way to speculate on a currency or hedge against foreign exchange risk in currencies you’d never be able to touch yourself.

• In a currency forward where physical delivery is not possible (e.g., due to regulations), the profit/loss is paid in a convertible currency like USD.

Commodity Forwards:

A commodity forward is similar to a private transaction to acquire or sell something concrete (like oil or wheat) at a predetermined price on a future date, a way for businesses to hedge their risk.

• For example, a farmer may want to lock in a price for their corn crop, or an airline may want to do the same thing for jet fuel. This makes budgeting easier for businesses and gives them protection against unexpected price movements.

Deliverable Forwards:

A deliverable forward is a simple contract where the actual asset is exchanged on an agreed date. It’s a “pay now, delivered later” contract. The buyer pays the price on the agreed price; the seller then delivers the asset, whether it’s currency, a commodity, or securities.

• For example, if a company has a deliverable forward contract to purchase US dollars, it sends euros and receives actual dollars when the deliverable forward expires. This type of contract is helpful when you need the actual asset to hedge against future price fluctuations.

Equity Forwards:

An equity forward is a private arrangement to purchase or sell shares of stock at a predetermined price on a specified date in the future. You are essentially locking in the price of a stock now for a transaction that will take place in the future. Investors use equity forwards for protection against market fluctuations.

• An example may be an investor wanting to lock in a price for Apple shares. The stock will be exchanged, which the parties will consummate, on the contract’s future date.

Interest Rate Forwards (Forward Rate Agreements – FRAs):

An Interest Rate Forward, or Forward Rate Agreement (FRA), is a contract that locks in an interest rate for a loan or deposit for a future date. It is, in effect, a protective agreement that hedges an interest rate risk. Under this agreement, two parties agree to a specified rate on a future loan with an agreement to settle on the specified date. Once the future date occurs, a seller of an FRA compensates a buyer of an FRA with the difference between the specified rate and the market rate on that date. Interest Rate Forwards help companies and other entities manage their future borrowing costs.

• In a currency forward where physical delivery is not possible (e.g., due to regulations), the profit/loss is paid in a convertible currency like USD.

Differences Between Forward and Futures Contracts

Forwards and futures are both types of derivative contracts, meaning that they legally bind the parties to buy/sell an asset at a future date and price. However, forwards and futures are distinctly different in terms of structure, trading, risk, and regulation. Futures are essentially standardized forwards that can be traded on an organized exchange with clearing houses as intermediaries.

Aspect	Forward Contracts	Futures Contracts
Trading Venue	Over-the-counter (OTC); private negotiation between two parties.	Traded on organized exchanges (e.g., Chicago Mercantile Exchange – CME).
Standardization	Highly customizable (quantity, quality, delivery terms).	Standardized terms set by the exchange (e.g., fixed contract sizes, expiration dates).
Regulation	Lightly regulated; no central authority.	Heavily regulated by bodies like the Commodity Futures Trading Commission (CFTC) in the U.S.
Counterparty Risk	High; risk of default by the other party, as there’s no intermediary.	Low; exchange’s clearing house guarantees the trade and acts as the counterparty to both sides.
Settlement	Typically settled at maturity (end of contract) via physical delivery or cash.	Daily mark-to-market settlement; profits/losses adjusted daily in margin accounts. Physical delivery is rare—most are cash-settled or closed out before expiration.
Margin Requirements	No initial margin; collateral may be negotiated privately.	Requires initial and maintenance margins; daily variations can lead to margin calls.
Liquidity	Low; harder to exit early without negotiating with the counterparty.	High; easy to buy/sell on the exchange at any time.
Cost	No exchange fees; may involve broker fees.	Involves exchange and clearing fees.
Purpose	Primarily for hedging in customized scenarios.	Used for hedging and speculation; more accessible to retail traders.

Example to Illustrate the Differences

Suppose that a coffee roaster wants to hedge against the risk of rising coffee beans prices six months from now.

• Forward Contract: The roaster negotiates to purchase 10,000 pounds of coffee beans, directly from a coffee farmer, at a price of $2 per pound and delivered in six months, to a specified account at their warehouse. The terms of the contract are customized terms (e.g., coffee bean quality and exact delivery location). There is no daily margin settlement for the contract—the roaster settles 10,000 pounds of coffee beans at the end of the six-month period. If the coffee farmer was not able to perform due to a bad harvest or other eventualities, the roaster would have to eat the foreclosure and potentially sue the coffee farmer or purchase beans from secondary sources.
• Futures Contract: The roaster purchases standardized coffee futures contracts at an exchange like the Intercontinental Exchange (ICE) to hedge against rising coffee prices. Each coffee futures contracts represents 37,500 pounds of coffee at a specified price (e.g., $2 per pound), with specific settlement date for a capital gain or loss, and a price in the open market between contracts on the exchange. At the exchange, the futures contract has an initial margin deposit required (e.g., 10% of the contract), and daily adjustments to profits or losses if the value changes on any day of the contract. The exchange does not have any risk of default due to the clearing house’s performance. The futures contract is standardized so that rebating the contract is as simple as selling on the exchange.

Conclusion

Forward contracts are customizable, powerful mechanisms for managing price risk through the OTC private negotiations of an individual agreement which will be useful for customized hedging in various asset classes including commodities, foreign exchange, equities or interest rates. They provide flexibility in terms, physical or cash delivery, and settlement to satisfy particular business needs but will also carry counter-party risk and lower liquidity. The other option is futures contracts which are more efficient, standardized, and exchange-traded. Futures will hold a minimal default risk from clearing houses and feature daily mark-to-market settlement and high liquidity which are useful for hedging and speculation among broader markets. In summary:

• Choose forwards when customization and personalized negotiation are priorities, and
• Choose futures when transparency, liquidity, and risk mitigation through institutional usage are priorities.

Both contracts offer the same basic utility of locking in a future price but structurally, their differences, risk profile, and accessibility, pre-negotiate for a different experience.

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