Forwards

A forward contract is a contract between two parties who are obligated to buy or sell an asset at a specified price on a particular future date. In a forward contract, one party goes long (buys) the underlying asset from the short (seller), at a forward price (predetermined specified price) on a fixed expiration date (future date) of the contract. If the spot price of the asset, on the expiration date, is greater than the forward price, then the long will benefit. Similarly, if the spot price of the asset is less than the forward price on expiration date, then short will be at an advantage while exercising the contract.

Though the linear payoffs of futures and forwards are similar, forwards are different from futures in the sense that they are customized instruments wherein the terms and conditions can be negotiated bilaterally and parties can incorporate any mutually agreed upon features in the contract. Further, customized nature of forwards contracts do not make them suitable to be traded over an exchange and hence, they are traded over the counter. As a result, the credit risk of the opposite party has to be taken into consideration while entering into a forward contract.

Example

Suppose on Jan 1, 2015, the spot price of gold is Rs. 15000 per 10 grams. You want to buy the gold on Feb 1, 2105, but want to get rid of the price uncertainty of the spot market. Hence, you enter into a forward contract with the goldsmith who quotes you a price of  Rs. 15100 for 10 grams of gold with one-month expiration. You agree to the forward contract for 10 gram of gold. After 1 month, you come back to the goldsmith pay him Rs. 15100 and collect your gold. This is a forward, where both the parties are obliged to go through the contract irrespective of the value of the underlying asset at the point of delivery.

Now on Feb 1, 2015, if the spot price of gold is Rs. 15,500 then you make a profit of Rs. 400 by entering into a forward contract with the goldsmith. Conversely, if the spot price would have been Rs. 14,900, you would have made a loss of Rs. 200.