Forward Contracts

A forward contract is a private, customized agreement between two parties to buy or sell an asset at a predetermined price on a specific future date. Think of it as a personalized handshake deal to lock in a price today for a transaction that will happen later. These contracts are a type of derivative, meaning their value is derived from an underlying asset, which could be anything from a commodity like oil or wheat, to a foreign currency, or an interest rate. Unlike their more famous cousins, futures contracts, forwards are traded directly between two parties in the over-the-counter (OTC) market, not on a public exchange. This customization is their greatest strength and weakness. It allows the terms (like the exact quantity and settlement date) to be tailored perfectly to the parties' needs, but it also introduces risks that are managed differently than in public markets. For the buyer, the contract is a promise to purchase, and for the seller, it's a promise to deliver.

Let's make this simple. Imagine you're a bread baker who needs 1,000 bushels of wheat in three months. You're worried the price of wheat will skyrocket. Meanwhile, a local farmer is worried the price will plummet before her harvest is ready. You two can enter a forward contract. You agree to buy her 1,000 bushels in three months for, say, $8 per bushel—today's price. You've just locked in your cost, and she has locked in her revenue. In market lingo:

• The baker, who agreed to buy, has a long position.
• The farmer, who agreed to sell, has a short position.

When the three months are up, one of two things happens:

• Scenario 1: The market price (spot price) of wheat has risen to $9 per bushel. The baker is thrilled! She gets to buy the wheat for $8, saving $1 per bushel. The farmer, while missing out on the higher price, is still obligated to sell at the agreed-upon $8.
• Scenario 2: The spot price of wheat has fallen to $7 per bushel. The farmer is relieved. She gets to sell her wheat for $8, earning $1 more per bushel than the current market rate. The baker has to honor the contract and buy at $8, even though it's cheaper on the open market.

Notice that no money changes hands when the contract is created. The deal is settled only at the end of the term.

People often confuse forwards with futures, but for an investor, the differences are critical. They are both agreements to transact in the future, but they operate in different worlds.

Forwards are the bespoke suits of the derivative world. Because they are private over-the-counter (OTC) agreements, the two parties can negotiate every detail: the exact asset, the precise amount (e.g., 1,375 barrels of a specific crude oil), and the exact date. Futures, on the other hand, are 'off-the-rack.' They are traded on organized exchanges (like the Chicago Mercantile Exchange) with standardized terms for asset quality, quantity (e.g., a contract for 1,000 barrels), and settlement dates. This standardization makes them easy to trade.

This is a big one. With a forward contract, you are relying entirely on the other party to make good on their promise. What if the farmer's crop fails, or the baker goes bankrupt? This is called counterparty risk. If one side defaults, the other is left holding the bag. In the world of futures, this risk is virtually eliminated. The exchange's clearing house acts as a middleman for every transaction, guaranteeing the trade. If one party defaults, the clearing house steps in. It protects itself by requiring traders to post collateral (called margin) and settling gains and losses daily through a process called marking to market.

Because a forward contract is a private, customized deal, it's very difficult to get out of. You're stuck with your counterparty until settlement day unless they agree to cancel the contract. This makes forwards highly illiquid. Futures are the opposite. Since they are standardized and traded on an exchange, you can exit your position at any time before expiration by simply selling your contract (if you were long) or buying one back (if you were short). This makes them highly liquid.

At first glance, forward contracts seem like tools for speculators or large corporations, not for the patient value investing practitioner. A value investor buys wonderful businesses at fair prices; they don't typically trade derivatives. However, understanding forwards is a crucial piece of the analytical puzzle.

Many great businesses use forward contracts not to speculate, but to hedge—that is, to reduce risk.

• An airline might use forwards to lock in the price of jet fuel to protect against rising oil prices.
• A multinational company like Coca-Cola, which earns revenue in euros, yen, and pesos, might use currency forwards to lock in exchange rates and make its U.S. dollar earnings more predictable.

When you analyze a company's financial statements, you may see derivatives listed. Understanding that the company is using forward contracts to sensibly hedge risk can be a sign of prudent management. It reduces earnings volatility and makes the company's future cash flows easier to forecast—a core task for any value investor.

Conversely, the misuse of derivatives can be a huge red flag. As Warren Buffett famously warned, they can be “financial weapons of mass destruction.” If a company's derivative positions seem more like wild bets than sensible hedges, it could be a sign of a speculative and dangerous corporate culture. A value investor prizes stability and predictability, and heavy, unexplained derivative use is the enemy of both. In short, while you probably won't be trading forward contracts yourself, knowing what they are and why companies use them expands your circle of competence. It allows you to better assess the risks and the quality of management of a potential investment.