What it means
The essential feature is obligation. When two parties enter a forward commitment they lock in a price and a date, and neither can walk away simply because the market has moved in their favour or against them.
That certainty is the product being bought. Businesses use forward commitments to take price risk out of things they know they will have to buy or sell.
An airline agreeing a fuel price for next winter, a miller agreeing a wheat price for next harvest and a manufacturer agreeing a copper price for a signed contract are all doing the same thing: swapping an unknown future cost for a known one. The commitment cuts both ways, and that is the part people forget.
If the market price falls below the agreed price, the buyer still has to pay the higher agreed amount, and the resulting loss on the contract is offset by cheaper conditions in the underlying business. A hedge is supposed to produce roughly the same net outcome regardless of which way prices move.
Forward commitments come in two broad flavours. Exchange-traded futures are standardised, cleared through a central counterparty and settled with daily margin, while over-the-counter forwards are negotiated privately and tailored to exact quantities and dates, at the price of counterparty risk.
There is a value question as well as a cash question. A forward commitment starts life worth close to nothing to both sides, then gains or loses value as the market price moves away from the agreed price, which is why it appears on the balance sheet as a derivative asset or liability.
In practice
Real-world examples.
Example
A regional airline commits to buy 12 million gallons of jet fuel next year at a fixed price per gallon. When fuel spikes, the contract cushions the cost; when fuel falls, the airline pays above market and accepts that as the cost of a stable schedule of fares.
Example
A chocolate manufacturer signs a forward commitment for cocoa covering the whole of its Christmas production run. Because the input cost is fixed before pricing negotiations with retailers begin, it can quote firm prices without guessing at the crop.
Example
A property developer agrees a forward commitment with an institutional buyer to sell a completed office block in two years at a fixed price. The developer gives up any upside in the property market but secures the exit that makes its construction loan possible.
Formula
Calculation
Value to the buyer at settlement = (Spot price at delivery - Agreed forward price) x Quantity. The same figure is the seller's loss or gain with the sign reversed.
An electrical equipment manufacturer knows it will need 400,000 pounds of copper in nine months for a signed order. It enters a forward commitment to buy that copper at $4.20 per pound, so the contract notional is 400,000 x 4.20 = $1,680,000.
Nine months later copper is trading at $4.65 per pound. Buying the same quantity in the open market would cost 400,000 x 4.65 = $1,860,000.
The value of the commitment to the manufacturer is (4.65 - 4.20) x 400,000 = $180,000, which is exactly the 1,860,000 - 1,680,000 difference in purchase cost.
Now suppose copper had instead fallen to $3.95. The market cost would be 400,000 x 3.95 = $1,580,000, and the commitment would be worth (3.95 - 4.20) x 400,000 = -$100,000. The manufacturer still pays $1,680,000, and the $100,000 loss on the contract is the cost of the certainty it bought.Case study
Seen in the real world.
Rowan Glass Works is an illustrative and fictional maker of specialist architectural glazing. Its two largest costs are natural gas for the furnaces and soda ash, and both had swung wildly enough over three years to make fixed-price building contracts genuinely dangerous.
The company began entering forward commitments for gas covering roughly 70% of its forecast furnace load twelve months ahead, timed to match the pricing of its longer construction contracts. Purchasing and estimating agreed a single rule: no fixed-price quote longer than six months without a matching forward position.
In the first year, gas prices fell, and Rowan paid about $340,000 more than spot for its hedged volume. In this fictional illustration the finance director resisted the temptation to abandon the policy, pointing out that the same contracts had protected two large projects the previous winter and that the purpose was a predictable bid margin, not a trading gain.
Watch out
Common mistakes.
- Describing a forward commitment as an option, when an option gives one party a choice and a forward commitment obliges both parties to perform.
- Judging a hedge only by whether the contract itself made money, ignoring the offsetting movement in the underlying purchase or sale it was protecting.
- Committing to volumes larger than the business will genuinely need, which converts a hedge into a speculative bet on the commodity.
Questions
People also ask.
What is the difference between a forward and a future?
A future is standardised, exchange-traded and margined daily, while a forward is a private contract tailored to your quantity and date with credit risk against the counterparty.
Do forward commitments require cash up front?
Typically not for over-the-counter forwards, though futures require initial margin and daily variation margin, and banks may demand collateral on large forward positions.
How is a forward commitment shown in the accounts?
As a derivative asset or liability at fair value, with the gains or losses reported in profit or loss unless formal hedge accounting is applied.
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