A forward contract, often referred to together with futures, is a derivative instrument that has a specific function: here is what it is, including risks and opportunities.
In the financial and trading fields, forward contracts are very important derivative instruments for those who operate on the markets. Knowing their meaning, functioning, risks and advantages can mean investing thoughtfully, also based on opportunities, at the right time.
Basically, we know that forward contracts allow investors to buy or sell an asset at a predetermined time and at a given price. But what is a forward contract? And, above all, how does it work? Here is everything you need to know.
What is a forward contract: definition and practical meaning
First of all, let’s start with the most practical and general economic-financial definition of forward contracts.
A forward is a customized financial agreement between two parties, in which it is agreed to buy or sell an underlying asset at a specific price, with delivery and payment set for a predetermined future date. These contracts are negotiated privately over-the-counter (OTC), outside of regulated markets, offering flexibility but also carrying certain risks.
This type of contract is mostly used as a hedging instrument to eliminate the volatility of the price of an asset, and the delivery of the asset, or net profit, usually takes place. But they can also be used for speculative purposes.
If we were to enclose the basic characteristics common to all forwards, we can define three in particular:
- customization: the parties involved can define specific details such as quantity, quality, place of delivery and expiration date of the underlying asset;
- absence of standardization: unlike futures contracts, as we will see, forwards do not follow pre-established standards, allowing greater adaptability to the needs of the counterparties;
- counterparty risk: being private agreements, there is a risk that one of the parties will not fulfill its obligations at the expiration of the contract.
The market for forward contracts is huge because many of the world’s large companies use it to cover exchange rate and interest rate risks. However, since the details of forward contracts are limited to the buyer and seller - and are not known to the general public - the size of this market is difficult to estimate.
What are forward contracts for: some examples to understand
As mentioned, forward contracts are derivative financial instruments used mainly for risk management and speculation on financial markets. Thanks to their customizable nature, they allow companies and institutional investors to fix today the price of an asset that will be traded in the future, protecting themselves from market fluctuations.
One of the main uses of forward contracts is, therefore, the hedging of exchange rate risk. Multinationals that operate in multiple currencies are exposed to forex fluctuations, which can have a significant impact on their balance sheets.
For example, a European company that must receive payments in dollars in six months can enter into a forward to lock in the current exchange rate, avoiding losses in the event of a depreciation of the dollar against the euro.
According to the Bank for International Settlements (BIS), the currency derivatives market reached a daily volume of over 7.5 trillion dollars in 2024, with a 15% increase compared to 2022 due to increased volatility in emerging markets.
Another sector in which forward contracts are widely used is that of raw materials. Producers and processing companies use forwards to stabilize the costs of resources needed for production.
For example, an airline could use a forward to lock in the price of fuel and protect itself from possible increases due to geopolitical tensions or reductions in supply.
According to a report by Bloomberg Commodities Outlook 2025, 60% of global energy companies use forward contracts to mitigate risks related to the volatility of oil and natural gas.
But not only that. As anticipated, in addition to hedging, forwards are also used for speculative purposes. Hedge funds and professional traders use these contracts to bet on the future price movement of currencies, stocks and raw materials, obtaining significant profits in the event of correct predictions. However, the lack of regulation in the OTC forward market can increase counterparty risk, making these trades particularly risky, as we will discuss later.
Differences between forwards and futures
Forwards and futures are derivative instruments that are often referred to together but have several differences. Here is a summary table of all the differences and characteristics of forward and futures derivative contracts, such as counterparty risk, centralized daily clearing and mark-to-market, price transparency and efficiency.
| . | Forwards | Futures |
| Definition | A forward contract is an agreement between two parties to buy or sell an asset (which can be of any type) at a pre-agreed time in the future and at a specified price. | A futures contract is a standardized contract, traded on the futures market, with which a specified underlying instrument is sold or bought at a specified date in the future, at a specified price. |
| Structure and Objective | Tailored to the needs of the client. Usually no initial payment required. Usually used as a hedge. | Standardized. Initial margin payment required. Usually used for speculation. |
| Transaction Method | Negotiated directly between seller and buyer | Listed and traded on the market |
| Market Regulation | None | Regulated by the relevant national authorities |
| Guarantor | The contracting parties | Clearing House |
| Risk | High counterparty risk | Low counterparty risk |
| Guarantors | No guarantee of compensation until the expiration date, the future price is based on the current price of the underlying. | Both parties must deposit an initial guarantee (margin). The value of the transaction is derived from market rates with daily definition of profits and losses. |
| Contract expiration | Forward contracts expire upon delivery of the asset | Futures do not necessarily mature only upon delivery of the asset |
The risks of the forward contract
The main risk of forward contracts lies in the biggest difference, ultimately, with futures.
Since forward contracts are private agreements, there is always the possibility that one of the parties will not fulfill what is foreseen in the agreement. Futures contracts on the other hand - and this is the biggest difference - are regulated by a clearing house (clearing house in English) that guarantees the transactions, which drastically reduces the chances of the parties going into default.
The large size and unregulated nature of the forward contracts market lead us to think that it could be subject to a series of cascading defaults. Although banks and financial institutions mitigate this risk by being very careful in their choice of counterparty, there is the possibility of large-scale default.
Another risk arising from the non-standard nature of forward contracts is that they are settled only on the settlement date, i.e. the date of conclusion of the contract. What happens if the forward price specified in the contract differs significantly from the spot price at the time of settlement? In this case, the financial institution that originated the forward is exposed to a greater degree of risk in the event of default or failure to settle by the customer than if the contract were defined as regularly marked-to-market.
Original article published on Money.it Italy. Original title: Cosa sono i contratti forward? Definizione e significato
