Forward contract
Also written Forward · Forwards · Long forward · Short forward
A bilateral, over-the-counter agreement between two parties to buy or sell an asset on a fixed future date at a price agreed today — customised to suit them, and binding on both.
In plain language
A forward is the simplest derivative there is: two parties shake hands today on a price for a delivery that happens later.
Nothing changes hands when the deal is struck. No money moves, no asset moves. On the agreed date the buyer pays the agreed price and the seller delivers — regardless of what the asset is worth in the market by then. That last clause is the whole point. The buyer has removed the risk that the price goes up; the seller has removed the risk that it goes down. Both have given up the chance of a favourable move to be rid of an unfavourable one.
Because the contract is negotiated privately between the two of them, every term is theirs to set: price, quantity, quality, delivery date, delivery place, how it settles. Nothing is standardised, and nothing can be altered later unless both agree.
How it works
Two features follow directly from the contract being private and tailor-made, and both are limitations:
It is illiquid. A contract written to one party's exact requirements is of little use to anybody else, and it is not listed anywhere a third party could find it. So a party who wants out before maturity has essentially one route — persuade the original counterparty to tear it up. There is no market to sell into.
It carries counterparty risk. Nobody stands behind the promise. Each side is relying on the other to perform at a moment when performing has become expensive. A party defaults precisely when it has the incentive to default: the seller walks away when prices have risen, the buyer walks away when they have fallen.
To those the workbook adds lack of transparency and settlement complications, since settlement has to be arranged directly between the two parties. Every one of these is a problem the futures contract was invented to fix.
A worked example
The workbook's gold example, worked through.
On 11 May 2024 the spot price of 24-carat gold is Rs 62,130 per 10 grams. You could buy it today at that price and walk out with the metal — that is a cash market transaction.
Instead you want delivery in one month. The goldsmith quotes Rs 62,337 for 10 grams, one month forward. You agree. You have bought a forward (you are long forward); he has sold a forward (he is short forward). No money and no gold move on 11 May.
One month later:
| Spot price on delivery day | You pay under the forward | Worth in the market | Your position |
|---|---|---|---|
| Rs 62,700 | Rs 62,337 | Rs 62,700 | Gain of Rs 363 per 10 g |
| Rs 62,337 | Rs 62,337 | Rs 62,337 | Nil |
| Rs 62,100 | Rs 62,337 | Rs 62,100 | Loss of Rs 237 per 10 g |
Notice what you did not get. At a spot price of Rs 62,100 you are still obliged to pay Rs 62,337 — a forward is not an option, and there is no walking away. And notice the second risk: if gold had run to Rs 70,000, the goldsmith's incentive to simply not show up would be very large indeed, and there is no clearing corporation to make him.
Why NISM asks about it
Chapter 3 (Introduction to Forwards and Futures), section 3.1, opens with exactly this gold example and then lists the essential features and the limitations. The examinable comparison is forward versus futures, and it is asked constantly: which is bilateral, which is standardised, which carries counterparty risk, which requires margin, which can be exited before maturity. Learn the limitations of the forward as a list, because section 3.2 is written as the answer to that list.
Common exam traps
- A forward is not an option. Both parties are obliged. The buyer of a forward cannot decline delivery because the price moved against him — that right costs a premium and belongs to option contracts.
- No money changes hands at inception. Candidates confuse the forward price with a payment made today. The forward price is a price agreed today and paid later.
- No margin, no daily settlement. The entire profit or loss lands on the delivery date in one lump. That is a feature of forwards and the reason the counterparty risk builds up unchecked.
- Illiquidity and counterparty risk are two separate limitations, not one. Questions often ask you to name them individually.
- Forwards are not listed on an exchange and are not guaranteed by any clearing corporation. Any answer option pairing "forward" with "exchange-traded" or "settlement guarantee" is wrong.
Where this is taught
- Series X-A · Chapter 10: Understanding Derivativesintroduced here
- Series XVI · Chapter 1: Introduction to Commodity Marketsintroduced here
- Series VIII · Chapter 1: Basics of Derivativesintroduced here
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series XXI-B · Chapter 5: Derivativesintroduced here
- Series X-B · Chapter 11: Taxation of Equity Productsintroduced here
- Series V-D · Chapter 15: Introduction to Forwards and Futuresintroduced here
- Series SEBI-ICE · Chapter 5: Investment in Securities Marketintroduced here
- Series XXI-A · Chapter 5: Derivativesintroduced here
- Series XVI · Chapter 3: Commodity Futures
- Series VIII · Chapter 3: Introduction to Forwards and Futures
Related terms
- Liquidity riskThe risk of being unable to get out of a position at or near the quoted price — because the contract is bilateral, because the order book is thin, or because volumes dry up near expiry.
- Futures contractA standardised forward traded on an exchange, where the exchange fixes every term except the price and the clearing corporation guarantees settlement, so neither side carries the other's default risk.
- Counterparty riskThe risk of an economic loss because the other party to a contract fails to fulfil its obligation — acute in forwards, and removed for exchange-traded derivatives by the clearing corporation's guarantee.
- OTC derivativeA non-standard derivative contract settled directly between counterparties on mutually agreed terms, relying on trust between them rather than on an exchange and clearing house.
- Spot priceThe price at which the underlying asset trades in the cash market for immediate delivery — the anchor from which futures prices, basis, moneyness and final settlement are all measured.
- Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.
- Bond forwardAn OTC rupee interest rate derivative in which a buyer agrees to buy a specific Government Security from a seller on a future date at a price fixed today — governed by RBI's Directions of 21 February 2025.
- Exchange traded derivativeA derivative traded on an organised exchange on standardised terms, with prices set by anonymous auction and performance guaranteed by a clearing corporation — as against a bilateral, customised OTC contract.
- Fixed-for-floating swapA commodity swap in which one side pays a fixed price agreed at the outset and the other pays a floating price — a spot price, a nearest-futures price, or an average of either — reset each period.
- Osaka Rice ExchangeThe first known organised futures market, set up in Japan in 1730, where rice bills issued against stored rice turned from title certificates into a right to future delivery at the current price.
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Non-deliverable forwardA cash-settled, usually short-term currency forward in which the notional amount is never exchanged — only the difference between the contracted rate and the reference rate changes hands.
- Foreign exchange forwardAn OTC derivative involving the exchange of two currencies on a specified future date more than two business days away, at a rate agreed on the date of the contract.
- SwapA derivative in which two parties agree to a specified exchange on future dates — typically one pays a fixed interest rate and receives a floating one on an agreed principal that never itself changes hands.
- Zero sum gameThe principle that every derivative long has a matching short, so one side's gain is exactly the other side's loss and the net value of all derivative positions is zero.