A forward contract is an agreement between two parties to exchange an asset at a predetermined price at a specific point in the future. The purpose of a forward contract is to help parties mitigate price volatility risks by "locking in" the asset's price at the current time for future delivery.

Key components of a forward contract include: the underlying asset (which could be commodities, stocks, interest rates, or currencies); the maturity date (the time of asset delivery); the predetermined price; the quantity (which can be adjusted between the parties); and the type of settlement (cash settlement or physical delivery). Forward contracts are over-the-counter (OTC) agreements. Compared to standardized futures contracts, forward contracts are more flexible, allowing parties to customize terms to suit their needs.

For example, if you purchase oil at a locked-in price of $50 per barrel and the oil price at the time of delivery is $55 per barrel, you will profit $5 per barrel. Conversely, if the price of oil drops to $40 per barrel, you will incur a loss of $10 per barrel. These scenarios illustrate how forward contracts operate and impact the gains/losses of the involved parties.

This model includes inputs such as settlement price, spot price, and transaction quantity. From there, it generates data tables and charts that illustrate various profit/loss scenarios.

The table describes two scenarios where the price of oil increases by $5 per barrel and decreases by $10 per barrel for the same quantity of goods, highlighting the differences in costs and potential profit/loss between using and not using a forward contract. Meanwhile, the line chart specifically shows the potential profit/loss that the crude oil buyer might face as prices rise or fall.

Source: Compiled