Forward Contracts The Basics

A forward contract is a legally binding agreement between two parties calling for the sale of an asset or product in the future at a price agreed upon today. The terms of the contract call for one party to deliver the goods to the other on a certain date in the future, called the settlement date. The other party pays the previously agreed-upon forward price and takes the goods. Looking back, note that the agreement we discussed between the wheat grower and the food processor was, in fact, a forward contract.

Forward contracts can be bought and sold. The buyer of a forward contract has the obligation to take delivery and pay for the goods; the seller has the obligation to make delivery and accept payment. The buyer of a forward contract benefits if prices increase because the buyer will have locked in a lower price. Similarly, the seller wins if prices fall because a higher selling price has been locked in. Note that one party to a forward contract can win only at the expense of the other, so a forward contract is a zero-sum game.

forward contract

A legally binding agreement between two parties calling for the sale of an asset or product in the future at a price agreed upon today.

Payoff Profiles for a Forward Contract

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