Forward contract

Definition

A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price that is agreed upon today. It is not traded on an exchange and typically used for hedging purposes.

5 Must Know Facts For Your Next Test

1. It is a type of derivative instrument.
2. Forward contracts are settled on the expiration date, not before.
3. They are subject to counterparty risk since they are over-the-counter agreements.
4. The terms of the contract, such as quantity, price, and delivery date, are customizable.
5. They can be used to hedge against foreign exchange rate risk.

Review Questions

• What distinguishes a forward contract from futures contracts?
• Why might a company use a forward contract in international trade?
• What are the main risks associated with entering into a forward contract?

Related terms

derivative: A financial security whose value depends on or is derived from one or more underlying assets.

futures contract: A standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future.

hedging: The practice of making an investment to reduce the risk of adverse price movements in an asset.