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.
Check yourself
1.Which of the following best describes a forward contract?
- a)A standardised contract traded on a recognised stock exchange with settlement guaranteed by a clearing corporation
- b)A bilateral over-the-counter agreement between two parties to buy or sell an asset on a future date at terms decided today
- c)An agreement that gives the buyer a right but not an obligation to purchase an asset later
- d)A contract in which only the seller is obliged to perform
Show the answer
Answer: (b) A bilateral over-the-counter agreement between two parties to buy or sell an asset on a future date at terms decided today
A forward is a bilateral OTC contract. All its terms — price, quantity, quality, place, settlement procedure — are fixed on the day of entering the contract, and altering any of them requires both parties to agree.
Option A describes a futures contract, which is the standardised, exchange-traded version. Option C describes an option, where only one side has a right. Option D is wrong on the most important point about forwards: both parties are obliged to go through with the contract, whatever the underlying is worth on the delivery date.
2.Why is it very difficult to exit a forward contract before its maturity?
- a)Because exchanges impose a regulatory lock-in on all forward contracts
- b)Because forwards are tailor-made and are not listed or traded on exchanges, so other participants cannot easily access them
- c)Because the clearing corporation refuses early termination requests
- d)Because forward contracts carry a very high exit penalty fixed by SEBI
Show the answer
Answer: (b) Because forwards are tailor-made and are not listed or traded on exchanges, so other participants cannot easily access them
This is liquidity risk. Forward terms are set to the specific requirements of the two parties, so other market participants may not be interested in that contract. And because forwards are not listed or traded on exchanges, others cannot easily reach either the contract or the contracting parties.
Options A, C and D all invent a regulatory or institutional barrier. The real barrier is simply that nobody else wants your uniquely shaped contract, and there is no marketplace in which to offer it.
3.Which statement about a futures contract is CORRECT?
- a)It is negotiated directly between two parties and its terms are customised
- b)It is similar to a forward except that the deal is made through an organised and regulated exchange, and it is standardised
- c)It gives the buyer a right but not an obligation to transact
- d)It involves the exchange of a series of cash flows according to a prearranged formula
Show the answer
Answer: (b) It is similar to a forward except that the deal is made through an organised and regulated exchange, and it is standardised
The workbook is compact on this: a futures contract is similar to a forward, except that the deal is made through an organized and regulated exchange rather than being negotiated directly between two parties. Futures are also standardised — in terms of lot size, maturity date and so on — so that they can be traded on the exchange. Its own one-line summary: futures are exchange traded forward contracts.
Option A describes a forward — negotiated between two parties, terms customised, an OTC contract.
Option C describes an option, the only one of the four products where one side has a right without an obligation.
Option D describes a swap, an agreement to exchange cash flows in the future according to a prearranged formula — broadly, a series of forward contracts.
The test that always works: if the question mentions an exchange or a clearing corporation, it is a future; if it mentions direct negotiation between two parties, it is a forward.
Where this is taught
- Series V-D · Chapter 15: Introduction to Forwards and Futuresintroduced here
- Series XVI · Chapter 1: Introduction to Commodity Marketsintroduced here
- Series SEBI-ICE · Chapter 5: Investment in Securities Marketintroduced here
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series VIII · Chapter 1: Basics of Derivativesintroduced here
- Series X-A · Chapter 10: Understanding Derivativesintroduced here
- Series X-B · Chapter 11: Taxation of Equity Productsintroduced 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 default by the counterparty to a contract.
- Over-the-counter (OTC) derivativeA derivative agreed directly between counterparties by telephone or electronic media.
- Spot priceThe price at which the underlying asset trades in the cash market right now.
- 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.
- 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.