SERIES 65 | FINANCIAL REGULATION COURSES
A forward contract is a privately negotiated bilateral agreement between two parties — most commonly a corporation and a financial institution — to buy or sell a specified quantity of an underlying asset at a predetermined price on a specified future delivery date, with all terms including the quantity, price, delivery date, and settlement method customised to the exact needs of the two contracting parties rather than standardised by an exchange.
The forward contract is the oldest derivative instrument in existence — merchants have used forward agreements to lock in prices for goods not yet delivered for centuries — and it remains one of the most widely used risk management tools in the global financial system, with enormous markets in currency forwards, interest rate forward agreements, and commodity forwards serving the hedging needs of corporations, financial institutions, and governments worldwide.
Unlike a futures contract — which is standardised, exchange-traded, centrally cleared, and subject to daily mark-to-market settlement — the forward contract is a bespoke over-the-counter agreement that trades privately between the two counterparties with no exchange involvement, no central clearing, and no daily settlement of gains and losses until the contract's final maturity date.
This flexibility is the forward contract's primary advantage over exchange-traded futures — the ability to specify any quantity, any delivery date, and any settlement terms makes forwards uniquely suited to hedging specific business exposures that do not fit the standardised specifications of exchange-listed futures.
Its primary disadvantage is counterparty risk — because there is no clearinghouse guaranteeing performance, each party bears the risk that the other will be unable or unwilling to fulfil its obligations at maturity. Forward contracts are tested on the Series 65 examination in the context of derivatives, hedging strategies, and the critical comparison with futures contracts.
Structure and Mechanics
A forward contract is entered into at zero cost — no premium is paid and no margin is posted at inception. The contract specifies the exact asset to be delivered, the quantity, the forward price at which the transaction will occur, the delivery date, and whether the contract will be settled through physical delivery of the underlying asset or through a cash payment equal to the difference between the forward price and the prevailing spot price at maturity.
At maturity the buyer of the forward — the long — is obligated to purchase the underlying asset at the agreed forward price regardless of what the current market price is.
If the market price at maturity exceeds the forward price the buyer profits — they acquire an asset worth more than they paid for it. If the market price at maturity is below the forward price the buyer suffers a loss — they must purchase at above-market cost.
The seller of the forward — the short — has the mirror-image obligation. If the market price at maturity is below the forward price the seller profits — they sell at above-market prices. If the market price has risen above the forward price the seller suffers a loss.
Because no money changes hands until maturity — unlike futures where gains and losses are settled daily — the full value of any gain or loss accumulates as an unrealised position throughout the contract's life, creating bilateral credit exposure that can become very large for long-dated contracts or in volatile markets.
The Major Forward Contract Markets
Currency forwards are by far the largest forward market by notional value — corporations with revenue or expenses in foreign currencies use currency forwards to lock in exchange rates for future transactions, eliminating the uncertainty of currency fluctuation from their financial planning.
An American company expecting to receive one million euros in six months can sell euros forward today, locking in the current forward exchange rate and eliminating the risk that the euro will depreciate before the payment arrives.
Interest rate forward agreements — commonly called FRAs — are contracts on a future interest rate, allowing borrowers and lenders to lock in a rate for a future period. An FRA is structurally the building block of an interest rate swap — a swap is essentially a series of FRAs bundled into a single contract. At settlement the difference between the agreed forward rate and the prevailing market rate is paid in cash by whichever party is out of the money.
Commodity forwards — particularly in oil, natural gas, agricultural products, and metals — allow producers and consumers to lock in prices for future delivery of physical commodities. Unlike standardised commodity futures traded on CME Group and the Intercontinental Exchange, commodity forwards can be structured for any delivery location, any quality specification, and any delivery date that suits the commercial needs of the two parties.
Counterparty Risk — The Defining Limitation
The absence of a central clearing counterparty is the defining limitation of the forward contract and the primary reason exchange-traded futures have displaced forwards for many standardised hedging applications.
In a forward contract each party bears the full credit risk of the other — the risk that the counterparty will default on their obligation at maturity.
For a corporate hedger entering into a currency forward with a major bank, this counterparty risk is typically modest because the bank is a highly creditworthy institution. For two corporations of uncertain creditworthiness entering into a commodity forward, the counterparty risk can be substantial — particularly for long-dated contracts where the accumulation of unrealised gains creates large bilateral exposures.
The Dodd-Frank Act of 2010 responded to the systemic risks created by large bilateral OTC derivative exposures by mandating central clearing for standardised swap contracts — pushing many instruments that had previously traded as bilateral forwards toward central clearing through registered derivatives clearing organisations. However non-standardised forwards and certain commercial hedging forwards remain outside the mandatory clearing framework and continue to trade as bilateral over-the-counter agreements.
Forward Contract Versus Futures Contract — The Critical Comparison
The comparison between forward contracts and futures contracts is the most directly tested concept in the forward contract curriculum on the Series 65 examination.
Forward contracts are private bilateral OTC agreements — customised in all terms, traded between specific counterparties whose identity is relevant, not centrally cleared, not marked to market daily, settled only at maturity, and subject to full bilateral counterparty credit risk.
They are flexible but illiquid — unwinding a forward before maturity requires negotiating a closing transaction with the original counterparty or a third party, which may be costly or difficult.
Futures contracts are standardised exchange-traded agreements — identical terms for all participants, traded anonymously through an exchange, centrally cleared through a clearinghouse that eliminates bilateral credit risk, marked to market and settled daily through the margin system, and highly liquid because any position can be closed by executing an offsetting trade on the exchange without involving the original counterparty.
Examination Relevance and Key Takeaways
Forward contracts are tested on the Series 65 examination in the context of derivatives, the comparison with futures, counterparty risk, and hedging applications.
The key points to retain are these.
A forward contract is a privately negotiated bilateral OTC agreement to buy or sell a specified asset at a predetermined price on a specified future date — all terms are customised to the two parties' exact needs. No premium is paid at inception and no margin is posted — the full gain or loss accumulates unrealised until maturity, creating bilateral counterparty credit risk. The buyer — long — profits when the market price at maturity exceeds the forward price. The seller — short — profits when the market price at maturity falls below the forward price.
The major forward markets are currency forwards — the largest by notional value used by corporations to lock in exchange rates for future foreign currency transactions — interest rate forward agreements — contracts on future interest rates that are the building blocks of interest rate swaps — and commodity forwards for physical commodity hedging. The critical distinction from futures is the absence of central clearing and daily mark-to-market settlement — forwards carry full bilateral counterparty credit risk while futures substitute clearinghouse credit risk for bilateral counterparty risk through central clearing.
