Forwards: OTC Structure, Delivery, Counterparty Risk, and Why Futures Were Invented

Before the financial engineer can price or hedge any derivative, they must understand what the derivative actually obligates the parties to do. The forward contract is the simplest possible derivative: a bilateral agreement to exchange an asset (or its cash value) at a future date for a price agreed today. No premium changes hands at inception; no exchange governs the deal; the two parties bear each other's credit risk until settlement.

This note establishes the forward's mechanics precisely, then traces the frictions that motivated the invention of exchange-traded futures. Understanding the differences — delivery terms, credit exposure, settlement structure, price discovery — is prerequisite to choosing the right instrument for any hedging or trading problem.

• state the payoff of a long and short forward position;
• describe the key provisions of a forward contract: delivery, settlement, counterparty risk;
• identify the three frictions in OTC forwards that exchange-traded futures resolve: double-coincidence, credit exposure, price opacity;
• explain why futures and forwards are economically similar but institutionally very different;
• use a forward contract to hedge a foreign-currency exposure.

1. The forward contract
2. Delivery and settlement
3. The three frictions of OTC forwards
4. Forward contract value before maturity
5. Why futures were invented