Legal Definitions - forward contract

A forward contract is a customized agreement between two parties to buy or sell an asset at a predetermined price on a specific future date. Unlike standardized contracts traded on public exchanges, a forward contract is privately negotiated and tailored to meet the specific needs of the parties involved. The terms, including the asset, price, and delivery date, are agreed upon today, but the actual exchange of the asset and payment occurs at the specified time in the future.

Here are some examples to illustrate how forward contracts work:

• Agricultural Commodities: Imagine a large bakery that needs a consistent supply of wheat for its bread production. The bakery is concerned that wheat prices might rise significantly before the next harvest. To manage this risk, the bakery enters into a forward contract with a wheat farmer. They agree today that the farmer will sell 5,000 bushels of wheat to the bakery for $7.50 per bushel, with delivery scheduled for October 15th, after the harvest. This is a forward contract because the price and quantity are fixed now, but the actual transaction (delivery of wheat and payment) will take place at a future date, providing price certainty for both parties.

• Currency Exchange: Consider a U.S. technology company that has ordered specialized components from a German supplier. The invoice for these components, totaling €500,000, is due in three months. The U.S. company is worried that the Euro might strengthen against the U.S. Dollar, making the payment more expensive. To hedge against this currency risk, the company enters a forward contract with its bank. The bank agrees to sell the company €500,000 in three months at a specific exchange rate, for example, $1.10 per Euro. This is a forward contract because the exchange rate for a future currency transaction is locked in today, eliminating the uncertainty of currency fluctuations for the U.S. company.

• Industrial Raw Materials: A furniture manufacturer relies heavily on a particular type of lumber. The manufacturer anticipates a surge in demand for its products in six months and wants to ensure it has enough raw material at a predictable cost. It enters into a forward contract with a lumber mill. They agree today that the mill will supply 100,000 board feet of lumber at a fixed price of $5.00 per board foot, to be delivered on a specific date six months from now. This demonstrates a forward contract because the manufacturer secures its future supply of lumber at a known price, protecting itself from potential price increases and ensuring production continuity.