Forwards

A forward contract is the simplest of the Derivative products. It is a mutual agreement between two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the seller at a future date. The Price of the contract does not change before delivery. These type of contracts are binding, which means both the buyer and seller must stay committed to the contract. This means they are bound to deliver or take delivery of the product on which the forward contract was agreed upon. Forwards contracts are very useful in hedging.
Example. The forward FX transaction

Important Characteristics of Forwards Contracts:

1. They are Over the counter (OTC) contracts
2. Both the buyer and seller are bound by the contractual terms
3. The Price remains fixed


Using forwards
An airline company that needs to purchase an amount of jet fuel in six months' time can enter into a forward transaction which fixes the price today. Whether the market price rises (or falls) in the interim is irrelevant; the company can budget around a predetermined level of fuel expenditure.

From forwards to futures
While many forward transactions are customized affairs, negotiated bilaterally between two parties, there is also a large market in standardized, fungible, forward agreements - futures contracts. A futures contract is based upon a particular type of forward transaction; the number of assets involved, the quality of those assets, and the days on which future transactions can be executed are all standardized. The standardization allows easy transferability, and positions can be liquidated simply by reversing the trade. Indeed, the vast majority of futures transactions (over 90%) are unwound before the pre-agreed delivery dates. One attraction of a futures transaction relative to an immediate transaction in an underlying asset is that initial outlay is usually much lower – a participant usually needs to post margin equivalent to only a small proportion of the underlying value of an asset. (In the case of a forward trade no margin at all may be necessary – assuming that the parties can agree on credit risk).


*In this sense, futures contracts are similar to securities, but it would be wrong to call a futures contract a security.