Locking in a future price, today
A forward is a contract: today, two parties agree to exchange a specific asset at a specific price on a specific future date. No money changes hands now (or only a small margin). The whole agreement is about that future trade at that pre-agreed price.
Why? Two reasons. The buyer wants to lock in the price now (maybe they're worried it'll rise). The seller also wants to lock in the price (maybe they're worried it'll fall). Both get certainty about the future transaction. Whoever ends up "right" about which way the price moved keeps the difference.
A worked example
A wheat farmer expects to harvest in 6 months. The current spot price of wheat is ₩200/kg. The farmer worries it'll drop. A bakery worries it'll rise. They sign a forward: in 6 months, the bakery will buy 1,000 kg of wheat from the farmer at ₩200/kg, no matter what the spot price is.
6 months later, three scenarios:
- Spot is ₩250/kg. The farmer "lost" — could have sold for more on the open market. The bakery "won" — got cheap wheat.
- Spot is ₩200/kg. Even — the contract just executed at the same price as the market.
- Spot is ₩150/kg. The farmer "won" — sold above market. The bakery "lost" — paid above market.
Both got what they actually wanted: certainty. The "winner" / "loser" framing is post-hoc.
Forwards vs. futures — the institutional difference
A future is essentially a forward, but standardized and traded on an exchange. Key differences:
- Standardized contract sizes, expiration dates, and asset specs (so they can trade on an exchange)
- The exchange acts as counterparty for both sides → no counterparty risk
- Daily mark-to-market — gains/losses settle every day, not just at expiration
- Margin requirements posted with the exchange
Forwards are private (over-the-counter); futures are public (exchange-traded). Practically, futures are what individuals access; forwards are what corporations sign with their banks for custom hedges.
How they're used
Three main use cases (lesson 8-6 expands these):
- Hedging. The farmer/bakery example. Lock in price to reduce uncertainty.
- Speculation. Take a position betting on price direction without actually owning the underlying. Levered.
- Arbitrage. Exploit small mispricings between forward and spot, or across markets.
Pricing — the cost of carry
The fair forward price for a non-dividend asset is approximately:
Where S is the spot price, r is the risk-free rate, and T is years to expiration. The forward price equals the spot price compounded forward at the risk-free rate. Why? Because anyone could buy at spot, hold to expiration (cost: financing at r), and have the asset at expiration — so the forward must equal that cost. Otherwise arbitrage.
For dividend-paying assets, subtract the dividend yield from r. For commodities with storage costs, add storage. The general principle is the same: forward = spot adjusted for cost of carry.
The takeaway
Forward = private agreement to trade an asset at a fixed price on a future date. Future = standardized exchange-traded version, daily mark-to-market, no counterparty risk. Used for hedging, speculation, arbitrage. Pricing follows cost of carry: F = S × (1+r)^T for simple cases. Foundation of all derivative thinking — options (next lesson) build on this.