# Forward Contract: How to Use It, Risks, and Example

## What Is a Forward Contract?

A forward contract is an over-the-counter (OTC) instrument customized between two parties to buy or sell an asset at a specified price on a future date. Used primarily for [hedging](https://www.investopedia.com/trading/hedging-beginners-guide/), these contracts offer flexibility in terms of commodities, amounts, and delivery dates but come with higher default risks due to their non-standardized nature and lack of a centralized clearinghouse.

Unlike futures contracts that are standardized and traded on exchanges, forward contracts tailor specifically to the needs of the parties involved, making them ideal for managing risks associated with fluctuations in commodity prices, interest rates, and foreign exchange rates.

### Key Takeaways

*   A forward contract is a customizable agreement between two parties to buy or sell an asset at a predetermined price on a future date, often used for hedging against price fluctuations.
*   Unlike futures contracts, forward contracts are over-the-counter (OTC) instruments that do not trade on a centralized exchange, leading to a higher risk of default.
*   Forward contracts are tailored to the specific needs of the buyer and seller in terms of commodity, amount, and delivery date, offering flexibility but also posing settlement risks due to their non-standard nature.
*   The lack of daily settlement or mark-to-market can expose parties to significant risks if market prices diverge dramatically from the agreed forward price.
*   Major corporations use forward contracts to hedge against currency and interest rate risks, contributing to a vast but largely opaque market due to the private nature of these contracts.

![Forward Contact](https://www.investopedia.com/thmb/FT41IQ4v_jsbdzYR6Thd5Ww1Jmo=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/ForwardContract_Final_4196098-a745f40c47f04d2fb8634295b4b8241b.jpg)

*— Investopedia / Paige McLaughlin*

## The Basics of Forward Contracts

Unlike standard [futures](https://www.investopedia.com/terms/f/futures.asp) contracts, a forward contract can be customized to a commodity, amount, and [delivery date](https://www.investopedia.com/terms/d/deliverydate.asp). [Commodities](https://www.investopedia.com/terms/c/commodity.asp) traded can be grains, precious metals, natural gas, oil, or even poultry. A forward contract settlement can occur on a cash or delivery basis.

Forward contracts do not trade on a centralized exchange and are therefore regarded as [over-the-counter (OTC)](https://www.investopedia.com/terms/o/otc.asp) instruments. Being OTC allows for custom terms, but the lack of a clearinghouse increases [default risk](https://www.investopedia.com/terms/d/defaultrisk.asp).

> **Important**
>
> Forward contracts carry default risk and lack a clearinghouse, making them less accessible to retail investors compared to futures contracts.

## Comparing Forward Contracts and Futures Contracts

Both forward and [futures contracts](https://www.investopedia.com/terms/f/futurescontract.asp) involve the agreement to buy or sell a commodity at a set price in the future. [But there are slight differences between the two](https://www.investopedia.com/ask/answers/06/forwardsandfutures.asp). While a forward contract does not trade on an exchange, a futures contract does.

[Settlement for the forward contract](https://www.investopedia.com/ask/answers/072915/how-does-forward-contract-differ-call-option.asp) takes place at the end of the contract, while the futures contract settles on a daily basis. Most importantly, futures contracts exist as [standardized contracts](https://www.investopedia.com/terms/c/contract-theory.asp) that are not customized between counterparties.

## Detailed Example of How a Forward Contract Works

Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its [financial institution](https://www.investopedia.com/terms/f/financialinstitution.asp) to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a [cash basis](https://www.investopedia.com/terms/c/cashbasis.asp).

In six months, the [spot price](https://www.investopedia.com/terms/s/spotprice.asp) of corn has three possibilities:

1.  **It is exactly $4.30 per bushel.** In this case, no monies are owed by the producer or financial institution to each other, and the contract is closed.
2.  **It is higher than the contract price, say $5 per bushel.** The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
3.  **It is lower than the contract price, say $3.50 per bushel.** The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.

## Understanding the Risks Involved with Forward Contracts

Many large corporations use forward contracts for [hedging](https://www.investopedia.com/terms/h/hedge.asp) currency and [interest rate risks](https://www.investopedia.com/terms/i/interestraterisk.asp), making [the market](https://www.investopedia.com/terms/b/buying-forward.asp) substantial. The details of forward contracts are private, making the market size hard to estimate.

The size and lack of regulation in the forward contracts market can lead to cascading [defaults](https://www.investopedia.com/terms/d/default2.asp) in worst-case scenarios. While banks and financial corporations mitigate this risk by being very careful in their choice of [counterparty](https://www.investopedia.com/terms/c/counterparty.asp), the possibility of large-scale default does exist.

A risk of non-standard [forward contracts](https://www.investopedia.com/terms/f/fixed-income-forward.asp) is they settle only on the [settlement date](https://www.investopedia.com/terms/s/settlementdate.asp), unlike futures that are marked-to-market. What if the [forward rate](https://www.investopedia.com/terms/f/forwardrate.asp) specified in the contract diverges widely from the [spot rate](https://www.investopedia.com/terms/s/spot_rate.asp) at the time of settlement? This exposes the originating financial institution to a higher risk of default or [non-settlement](https://www.investopedia.com/terms/e/event-of-default.asp) compared to regular mark-to-market contracts.

> **Article Sources**
>
> 1.  CME Group. "[Futures Contracts Compared to Forwards](https://www.cmegroup.com/education/courses/introduction-to-futures/futures-contracts-compared-to-forwards.html)."