A forward contract is a customized private agreement between two parties to buy or sell an asset at a predetermined price on a specific future date.

Unlike standardized futures contracts that trade on public exchanges, forward contracts are negotiated directly between two parties, in what is known as an over-the-counter (OTC) market. This allows the terms of the contract—such as the exact asset, quantity, and delivery date—to be tailored to the specific needs of the buyer and seller. The primary purpose of a forward contract is for hedging against price fluctuations.

What Defines a Forward Contract? 🔎

• Customizable ⚙️: All terms are negotiable, providing maximum flexibility to fit the specific needs of the parties.
• Private (OTC) 🔒: The contract is not public, and its terms are confidential between the two parties.
• Obligatory ⛓️: Both parties are legally bound to fulfill their side of the agreement, regardless of the market price of the asset on the delivery date. This is not an option, but a firm commitment.
• Counterparty Risk ⚠️: Because it's a private agreement without a central clearing house, there is a risk that one party may default on their obligation.

How a Forward Contract Works: A Farmer and a Baker 👩‍🌾➡️🥐

Imagine a Polish farmer 👩‍🌾 expects to harvest 10 tonnes of wheat 🌾 on October 1st. The current price is high, and she fears it might drop 📉 by harvest time. Separately, a large Warsaw bakery 🥐 needs to buy 10 tonnes of wheat on that same date and worries the price might rise 📈.

They enter into a forward contract today (August 14th 🗓️) to exchange 10 tonnes of wheat on October 1st at today's agreed-upon price 💰.

• If the market price of wheat falls 📉, the farmer is protected 🛡️. She still sells her wheat at the higher, pre-agreed price.
• If the market price of wheat rises 📈, the bakery is protected 🛡️. It still buys the needed wheat at the lower, pre-agreed price.