Forward Contract

The Definition

A forward contract is a contract between two parties that outlines the sale or purchase of something at a set price on a date in the future. It is normally arranged by a cash or delivery basis agreed upon by both parties. The time and the price of the item is fixed at the time the exact contract is executed. Sometimes, forward contracts can be confused with futures contracts. Though they have many similarities, forward contracts do not trade on an exchange. They also settle at the end of the contract term. Those who use forward contracts are mainly people who want to hedge the volatility inherent in the asset itself. Large companies use forward contracts to hedge currencies and interest rates, as forward contracts are highly customizable.

Example of Forward Contract

A local hamburger joint has been in business for many years, and is nationally acclaimed to being some of the best burgers one can eat. However, recently, the restaurant has been losing money on french fries due to the increasing amount of potato prices. To solve this problem, the restaurant contacted a large potato farmer, and the two decided to engage in a forward contract together. In this contract, the restaurant agreed to buy 1,000,000 potatoes at $5 per bushel, and the if the potatoes are to be delivered to the restaurant within 6 months, the potato farmer would receive a cash settlement for the goods. During this time, if the market price of potatoes decreases, the farmer would make more money. If it increases, then the farmer would lose money. For the restaurant, however, this contract locks in a set price on potatoes, and allows them to project how much they are to sell their french fries without the possibility of losing any money in french fry sales.