Forward Contract

A Forward Contract is an over-the-counter agreement between two parties to buy or sell an asset at a particular time in the future for a specific price. The terms-long hedge and short hedge refer to whether a party to a forward contract is a buyer or a seller.

• The party that has agreed to buy in anticipation of a possible increase in the price of an underlying asset is said to have a long position.
• The party that has agreed to sell in anticipation of a possible decline in the price of an underlying asset is said to have a short position.

The distinguishing characteristic of a forward contract is that they are not traded on any exchange. They are therefore called “over-the-counter.” Dealers bring together the buyer and the seller, who then negotiate the terms of the contract.

How is a Forward Contact Settled?

Settlement of the forward contract can occur either by cash or by delivery. In addition to the cash payment from the buyer, an agreement made on a delivery basis will require the seller to supply the asset to the buyer on the settlement date. On the other hand, a contract made on a cash basis merely requires a cash settlement between the buyer and seller on the settlement date. The cash settlement amount is based on the difference between the current market price and the agreed contract price. If the market and contract prices are the same on the settlement date, no money changes hands, and the contract is closed.