The forward market provides a way for parties to pay a fixed price “upfront” for a product to be delivered at an agreed upon date in the future. Originating almost two centuries ago, this market is still common today (a good example would be buying a house that is not yet built), but there are some limitations to it, including:

1. Forward contracts lock in prices with a future delivery.
2. Forward contracts can be specific and customized agreements.
3. Forward contracts contain an element of default in the future.
 

Originally, farmers and merchants tried to deal with the causes and effects of price uncertainties, and began making deals called forward contracts or cash forward sales. A cash forward sale, or forward contract, is a private negotiation made in the present that establishes the price of a commodity to be delivered in the future. The commodity does not change hands until the agreedupon delivery date. Farmers and merchants liked these arrangements because they could lock in prices ahead of time and not worry about price fluctuations in the interim. Importers and exporters
who frequently purchase products in foreign currencies operate in the same way.
 

Forward contracts were useful, but only up to a point. They didn’t eliminate the risk of default among the parties involved in the trade. For example, merchants might default on the forward agreements if they found the same product cheaper elsewhere, leaving farmers with the goods and no buyers. Conversely, farmers could also default if prices went up dramatically before the forward contract delivery date, and they could sell to someone else at a much higher price.
 

To resolve this problem, exchanges like CME Group began requiring each party in a forward transaction to deposit a sum of money with a neutral third party — similar to an escrow account in a real estate transaction. This helped ensure that both sides would live up to the agreement. If either defaulted, the other party would receive the money as reimbursement for any inconvenience or financial loss.

The exchanges also needed ways to address price changes resulting from unforeseen events such as crop failure, drought, war, and so on. They found that developing standardized contracts was helpful. A standardized contract specified a certain quality and unit of measurement for each commodity being traded. Standardized contracts were interchangeable and addressed everything except the price

Comparison Table: Forwards vs. Futures