Forward Contract
1. Definition
A Forward Contract is a customized, private agreement between two parties to buy or sell an asset at a specified price on a future date. * Unlike Futures, Forwards are traded Over-the-Counter (OTC) and are not standardized.
2. Key Features
2.1. Customization
Since it is a private contract, the terms (expiration date, quantity, quality of asset) can be tailored to the specific needs of the counterparties. (e.g., A farmer selling exactly 12.5 tons of wheat on November 12th).
2.2. Counterparty Risk (Default Risk)
Because there is no central clearinghouse to guarantee the trade, there is a risk that the other party may default on their obligation at expiration.
2.3. Settlement
There is no daily "Mark-to-Market" settlement. Profits and losses are realized only at the maturity date (expiration).
3. Payoff Structure
- Long Position (Buyer): Agrees to buy the asset. Profits if the market price rises above the agreed delivery price. * Payoff = $S_T - K$
- Short Position (Seller): Agrees to sell the asset. Profits if the market price falls below the agreed delivery price. * Payoff = $K - S_T$
4. vs. Futures
| Feature | Forwards | Futures |
|---|---|---|
| Market | Over-the-Counter (OTC) | Organized Exchange |
| Contract | Customized | Standardized |
| Risk | High Counterparty Risk | Low (Guaranteed by Clearinghouse) |
| Settlement | At Maturity only | Daily (Mark-to-Market) |
| Primary Use | Commercial Hedging | Speculation, Arbitrage |