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What is a forward and who uses them?

Forwards are the over the counter equivalents of futures contracts. (Futures contracts are legally binding commitments to deliver or take delivery of a specified quantity or quality of a commodity at a specified future time for a specified price.) A forward allows the holder to make or take delivery of the underlying commodity or financial instrument at some time in the future at a price that has been negotiated based on today’s market values. Unlike a future, forwards are contracts between two individuals rather than a contract negotiated on an exchange floor.

Forward contracts have an advantage over futures contracts, because the details can be tailored to meet the exact needs of the parties. Forwards, however, suffer from illiquidity, because there may not be another party willing to accept such a specific contract. Another risk with forwards is default risk. Futures are cleared through a clearing corporation, which guarantees performance of the contract. Forwards are backed only by the credit worthiness of the two parties.

Most forward contracts are issued by banks to hedgers (use forward contracts as a form of insurance) such as pension funds, manufactures and corporations. Contracts are usually very large and are either held to maturity or reversed upon the request of one of the parties. If the contract is reversed it is usually to the disadvantage of the party requesting the reversal. The largest players in this market are the banks, who trade both foreign exchange and interest rate products.