Forward contracts are a type of derivative which helps us to purchase or sell something on a future date.
Let’s meet Mr John who will help you in understanding this better John is running a cafe. He’s worried about the rising coffee bean price. He’s buying coffee beans currently at rupees 20 per bag and he is thinking that it’s going to increase up to Rupees 35 in a month’s time. Who is coming here to help him, yes Rosie? Rosie is a coffee bean merchant. She contracts with John to sell 10 bags of beans @ 30 per bag after one month. Imagine that after one month the actual market price of bean went up to Rupees 34. So because of Rosie’s contract John can buy them at Rupees 30 and save rupees 4 per bag. Here Rosie made this contract based on John’s requirement. Such customized contract between two parties to buy or sell an asset at a specified price on a future date is called forward contracts since they are customised contracts they are non-standardized in nature and they do not trade on a centralized exchange.
The good thing about forwards is that it helps to freeze the future price today and in that way help us to manage the future risk and act as an instrument to hedge the risk.