What it means
Every forward contract needs an agreed price, and that price is set so that neither side gains an advantage at the moment the contract is signed. If it were set anywhere else, one party could combine the contract with a purchase in the spot market and produce a risk-free gain, which competing traders would quickly compete away.
The building block is the cost of carry, meaning everything it costs to buy the asset today and hold it to the delivery date. Financing the purchase costs interest, physical goods cost money to store and insure, and any dividends, coupons or rental income the asset throws off in the meantime reduce the net cost.
For financial assets the arithmetic is straightforward because there are no storage costs, only interest and income. For commodities it is messier, since storage capacity, spoilage and something called convenience yield, meaning the practical benefit of physically having the goods to hand, all feed into the number.
The gap between the forward price and the spot price is not profit for anyone. A forward price above spot, sometimes described as contango, usually just means financing and storage outweigh income, while a forward price below spot, called backwardation, often signals a shortage of the physical asset today.
The point that trips people up in meetings is that the forward price does not have to equal the expected future spot price, and usually will not. Two people can agree on a forward price and still disagree completely about where the market will actually be on the delivery date.
In practice
Real-world examples.
Example
A coffee roaster asks two brokers for a nine-month forward price on green beans. Both quotes land within a few cents of each other because both are built from the same spot price, warehouse costs and financing rate, not from either broker's market view.
Example
A pension fund wanting exposure to an equity index without buying every constituent share checks the forward price against the index level. Because the index yields more in dividends than the cost of financing, the forward price sits slightly below the spot level, which the fund recognises as normal rather than a bargain.
Example
A natural gas trader notices that the twelve-month forward price has fallen below the spot price during a cold snap. The pattern tells him that buyers are paying a premium for gas available now, which is a signal about physical tightness rather than a view that prices will collapse next year.
Formula
Calculation
Forward price = spot price x (1 + financing rate for the period) - income received during the period, with storage and insurance added for physical goods.
An investor wants a one-year forward price on a share currently trading at $80. The one-year risk-free rate is 5%, and the company is expected to pay a single dividend of $2 per share just before the forward contract matures.
Cost of financing the purchase = $80 x 5% = $4.
Value at maturity before income = $80 + $4 = $84.
Less the dividend the holder receives = $84 - $2 = $82.
The fair forward price is therefore $82 per share. If a dealer quoted $85 instead, a trader could sell the forward, borrow $80 to buy the share today, collect the $2 dividend and repay $84 at maturity, banking $3 per share with no market risk.Case study
Seen in the real world.
This illustrative story features an invented business. Selwyn Metals Trading, a fictional scrap and alloy dealer, priced its six-month customer contracts by taking the spot price and adding what the managing director called a sensible margin. When financing rates rose sharply over one year, those contracts started losing money even though the metal price itself had barely moved.
A new finance manager rebuilt the pricing sheet around the cost of carry. She showed that a $500 per tonne spot price with six months of financing at 8% and $10 of storage implied a forward price of $530, while the company had been quoting around $515 and absorbing the difference.
Selwyn changed its quoting method so the financing rate was pulled from the company's actual borrowing cost each week. Margins on the fictional company's forward book recovered within two quarters, and the sales team could finally explain to customers why a six-month price was not simply today's price with a mark-up.
Watch out
Common mistakes.
- Assuming the forward price is the market's best guess at the future spot price, when it is a cost-of-carry calculation.
- Leaving out income such as dividends or coupons, which makes the calculated forward price too high.
- Using a generic interest rate rather than the actual cost of funding the position, which quietly erodes margin when rates move.
Questions
People also ask.
Why is the forward price sometimes lower than the spot price?
Because income or convenience yield exceeds financing and storage costs, a pattern known as backwardation.
Does the forward price change after the contract is signed?
The agreed price is fixed for that contract, but the market's forward price for new contracts of the same maturity moves continuously.
Is the forward price the same as a futures price?
They are close and driven by the same logic, though daily settlement and interest rate movements can push futures prices slightly away from forwards.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%