A forward contract example is easiest to follow with real numbers, so start here: AlphaTech, a U.S. electronics manufacturer, owes a German supplier €5,000,000 in six months and wants to know today exactly what that bill will cost in dollars. It signs a forward contract with Global Bank to buy €5,000,000 in six months at a locked-in rate of $1.0950 per Euro. From that moment, AlphaTech’s cost is fixed at $5,475,000, no matter where the EUR/USD exchange rate goes. That single trade is the whole mechanic of a forward: a price agreed today for a transaction that settles on a specific future date.
The rest of this walkthrough fills in how the $1.0950 rate was set, how the contract settles on the delivery date, what happens in each of the three ways the market can move, and what AlphaTech is giving up in exchange for the certainty.
The Pieces of the Contract
Every forward names the same handful of terms. AlphaTech holds the long position: it has agreed to buy the Euros. Global Bank holds the short position: it has agreed to deliver them. Both sides are locked in once the contract is signed.
The underlying is what’s being traded. Here it’s Euros, but it could be a commodity like wheat or oil, an interest rate benchmark, or an equity index. The contract specifies the quantity (€5,000,000), the delivery date (six months from signing), and the forward price ($1.0950 per Euro). That forward price does not move between the day of signing and the day of settlement.
Where the $1.0950 Comes From
The forward price is not a forecast. For currency forwards, it comes out of the current spot rate and the interest rate difference between the two currencies over the life of the contract. The relationship is called covered interest rate parity, and it exists so that nobody can earn a risk-free profit by borrowing in one currency, converting at spot, and investing in another.
The formula multiplies the current spot rate by (1 + the domestic interest rate for the period) divided by (1 + the foreign interest rate for the period). If the domestic currency pays a higher interest rate than the foreign one, the forward price sits above the spot price. If it pays less, the forward price sits below.
For AlphaTech’s trade, assume the spot rate is $1.0800, the annualized six-month U.S. Dollar rate is 5.0%, and the Euro rate is 2.2%. Half-year rates are 2.5% and 1.1%. Plug in: $1.0800 × (1.025 ÷ 1.011) ≈ $1.0950. Any bank quoting a materially different number would be opening an arbitrage window the market would close within minutes.
How the Contract Settles on the Delivery Date
Six months in, the forward reaches its delivery date and the parties settle. Two methods exist, and AlphaTech’s economics come out the same either way.
Physical Delivery
For major pairs like EUR/USD, the standard is physical delivery. Global Bank wires €5,000,000 to AlphaTech. AlphaTech wires $5,475,000 to Global Bank. The currencies actually change hands. This is the obvious choice when the buyer genuinely needs the foreign currency, as AlphaTech does to pay its supplier.
Cash Settlement
When physical delivery is impractical, only the difference between the forward price and the spot price on the delivery date changes hands. This is the defining feature of a non-deliverable forward, which the CFTC describes as a contract “on a notional amount where no physical settlement of the two currencies takes place at maturity” and where “a net cash settlement is made by one party to another based on the difference of the two FX rates.”1CFTC. Non Deliverable Forwards Non-deliverable forwards are the norm for currencies with capital controls or limited convertibility, such as the Chinese Yuan or Brazilian Real.
The Three Outcomes
The payoff formula for the long position is: (Spot Price on Delivery Date − Forward Price) × Contract Size. Positive means AlphaTech profits on the contract. Negative means Global Bank does. Here is how each case plays out.
Scenario A: The Euro Rises to $1.1500
AlphaTech’s hedge did exactly what it was supposed to. The company locked in $1.0950 while the market moved to $1.1500. The gain on the contract is ($1.1500 − $1.0950) × 5,000,000 = $275,000.
Under cash settlement, Global Bank pays AlphaTech $275,000. AlphaTech then buys €5,000,000 on the spot market for $5,750,000 and nets the $275,000 against that, landing at $5,475,000 all-in. Under physical delivery, AlphaTech simply pays $5,475,000 and receives the Euros directly. Same number, different plumbing. Global Bank absorbs a $275,000 loss on the trade.
Scenario B: The Euro Falls to $1.0500
Now the market has moved against AlphaTech’s locked-in rate. The loss on the contract is ($1.0500 − $1.0950) × 5,000,000 = −$225,000.
AlphaTech pays Global Bank $225,000. If it then buys €5,000,000 on the spot market at $1.0500, that costs $5,250,000. Add the $225,000 settlement payment and the total is again $5,475,000. AlphaTech “lost” on the forward in the sense that unhedged Euros would have been cheaper, but that comparison was never the point. The CFO locked in a known cost and removed the risk of a worse outcome. Global Bank earns $225,000.
Scenario C: The Euro Lands on $1.0950
If the spot rate on the delivery date is exactly $1.0950, the contract settles at zero. Neither party owes the other anything. AlphaTech pays $5,475,000 for its Euros whether through the forward or the open market. The hedge served its purpose at no net settlement cost.
What AlphaTech Actually Bought
The number worth staring at across all three scenarios is $5,475,000. It is the same in every case. That is the entire reason AlphaTech signed the forward. The company was not trying to beat the market. It was trying to make a line item on next quarter’s budget stop being a variable. A forward does that by transferring price uncertainty from AlphaTech to Global Bank in exchange for a rate the two sides agreed to upfront.
Any gain or loss AlphaTech recognizes on the contract falls under Section 988 of the Internal Revenue Code, which requires that foreign currency gains and losses be “computed separately and treated as ordinary income or loss.”2Office of the Law Revision Counsel. 26 U.S. Code 988 – Treatment of Certain Foreign Currency Transactions For a hedger like AlphaTech, ordinary treatment usually matches up well with the ordinary character of the underlying business expense the contract protects.
Why Not Just Use a Futures Contract?
A reasonable question, since Euro futures trade on the CME with a clearinghouse guaranteeing both sides and an exchange price available every second of the trading day. The answer is customization.
A CME Euro futures contract has a fixed size of €125,000 and quarterly expiration dates. For AlphaTech to approximate its hedge, it would need to buy 40 contracts and accept whichever quarterly expiration sits closest to its payment date. If the supplier payment is due on a Tuesday in the middle of a quarter, the hedge won’t line up precisely. The forward, by contrast, is written for €5,000,000 flat and whatever delivery date AlphaTech names.
What AlphaTech gives up for that precision is liquidity and the clearinghouse backstop. Futures are easy to buy and sell before expiration. Forwards are not. For a company with a specific known obligation in a major currency, the fit of a forward usually wins. For a trader who wants the option to exit a position at will, futures are the better tool.
The Risks the Example Glosses Over
Counterparty Risk
This is the headline risk of any forward. The deal is private and bilateral. No exchange or clearinghouse stands between AlphaTech and Global Bank. If Global Bank became insolvent before the delivery date, AlphaTech might never receive its settlement payment. The Chicago Fed has put the point plainly: “OTC off balance sheet products incur credit risk due to the potential default of the counterparty prior to contract maturity.”3Federal Reserve Bank of Chicago. Reducing Credit Risk in Over-the-Counter Derivatives
Institutional counterparties manage this through ISDA Master Agreements, Credit Support Annexes that require collateral posting, and close-out netting provisions that collapse all outstanding trades into a single net amount if one side defaults. These tools reduce the exposure but do not eliminate it. Before signing, each side assesses the other’s creditworthiness, and the documentation lets either party demand additional collateral if the other’s credit deteriorates.
FX forwards sit in an unusual regulatory place. In 2012, the U.S. Treasury Department formally determined that FX swaps and FX forwards “should not be regulated as swaps” under the Dodd-Frank Act and exempted them from the law’s mandatory clearing requirements.4Federal Register. Determination of Foreign Exchange Swaps and Forwards Under the Commodity Exchange Act FX forwards like AlphaTech’s remain bilateral and dependent on the counterparty’s ability to pay. They do still have to be reported electronically to a swap data repository under CFTC rules, with the reporting obligation typically falling on the dealer when a dealer is one of the parties.5eCFR. 17 CFR Part 45 – Swap Data Recordkeeping and Reporting Requirements
No Easy Exit
A forward has no secondary market. If AlphaTech’s German deal collapsed three months in, the company could not sell its forward on an exchange. It would have to negotiate directly with Global Bank to unwind the position. The bank would value the contract based on where the forward rate for the remaining period sits at that moment, discount the difference to present value, and one party would pay the other to tear the trade up. How clean that process is depends entirely on Global Bank’s willingness to cooperate and the market conditions at the time. Illiquidity is the price of a custom contract.
Collateral Calls
If the Credit Support Annex in the ISDA documentation requires daily collateral posting, a sharp move in the EUR/USD rate can force the losing side to come up with cash on short notice. A hedge that works perfectly at the delivery date can still create liquidity strain in the months leading up to it. This is a detail worth negotiating carefully, not a boilerplate section to sign through.
None of these risks changes the shape of AlphaTech’s example. The $5,475,000 number holds in every scenario the market can produce. But a forward is a commitment to a specific counterparty for a specific period, and the price of certainty on the delivery date is accepting whatever happens between the parties in the meantime.