A forward contract is a contract between the buyer and the seller where both parties are obligated to complete the transaction: the buyer of the forward contract agrees to buy the underlying asset at a specified price on a specified date, holding the long position; the seller of the contract must sell the underlying asset at the specified price on the specified date, holding the short position.
Unlike options, which can expire with no action taken (since they are not obligated to transact), all forward contracts must be executed.
Forwards vs. futures
Forwards can be traded over-the-counter (OTC) or on an exchange. When a forward is traded OTC, it is called a forward agreement. When a forward is traded on an exchange, it is called a futures contract.
Futures are categorized into one of two main groups, depending on the underlying asset. If the underlying asset is a financial asset, it is a financial futures contract. If the underlying asset is a physical asset, it is a commodity futures contract.
Financial futures
The underlying asset of a financial future is a financial asset: stocks, bonds, currencies, interest rates, or stock indexes. Futures contracts that have an underlying asset that’s impossible to deliver, such as interest rates, are settled in cash. This amount is based on the performance of the underlying asset at the time that the contract was entered into.
For example, in an equity index futures contract, the long position holder is not required to deliver the stocks that make up the index, but would deliver a cash payment based on the difference between the price agreed to in the contract and the price of the underlying asset on expiration date.
Commodity futures
The underlying asset of a commodity future is a commodity such as precious metals, crude oil and natural gas; grains and oilseeds; meats and dairy; lumber.
If the price in the contract is greater than the price of the underlying asset at expiration, prices have fallen and the long position must pay the short position.
If the price in the contract is lower than the price of the underlying asset at expiration, then prices have risen and the short position must pay the long position.
