Lesson 1 of 7 · 11 min
Forward contracts and firm commitments
A forward locks in today the price at which one party will buy and the other will sell an underlying on a future date, so at maturity one side's gain is exactly the other side's loss.
In short
- A firm commitment obliges both counterparties to perform. Forwards, futures and swaps are all firm commitments.
- A forward contract is an OTC agreement: the buyer (long) will buy the underlying from the seller (short) at the forward price on date T.
- No money changes hands at inception. At maturity the buyer's payoff is and the seller's is .
- Because nothing is paid up front, a forward's payoff equals its profit. The payoff line is straight, so firm commitments are called linear derivatives.
- Forwards are flexible (size, date, underlying, credit terms) but carry counterparty credit risk. Settlement is by delivery or in cash.
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