A forward contract is a private agreement between a buyer and a seller regarding the transfer of an asset, such as a commodity, property or financial instrument. The agreement calls for the buyer to pay a set amount, called the forward price, on a predetermined settlement date in exchange for taking receipt of the asset from the seller on or around that date. No money changes hands until the settlement date.
How the Contract Works
As an example of how forward contracts work in the real world, consider a farmer who plans to plant wheat seed in the spring in sufficient quantity to yield 5,000 bushels at harvest. Rather than gambling on the price of wheat at harvest time, the farmer enters into a forward contract with a regional wheat mill. The contract calls for the farmer to deliver 4,500 bushels on September 15 for a price of $7 a bushel. The farmer and the mill have locked in a price to be paid on the settlement date. The farmer has removed price risk for most of his harvest, but has taken on two other risks. The first is that he produces less than the required 4,500 bushels, in which case he will have to make up the difference by buying additional wheat at the then-current price -- which may be higher or lower than $7 a bushel. The second risk is that the farmer may miss out on extra profit if wheat exceeds $7 a bushel on the settlement date.