Forward Contract Obligations: Buyer (Long) vs Seller (Short)

Imagine you’re planning a big birthday party a few months from now. You know you’ll need a fantastic cake. To make sure you get exactly what you want and at a price you’re happy with today, you visit your favorite bakery and agree to a future cake purchase. This is similar to entering a forward contract.

A forward contract is essentially a private agreement between two parties to buy or sell an asset at a specific future date for a price agreed upon today. Think of it as a personalized promise. In this cake example, you, the party planner, are like the buyer, also known as taking the ‘long position’. The bakery, agreeing to bake and deliver the cake, is like the seller, or taking the ‘short position’.

Let’s break down the obligations for each party in this forward contract, using financial assets instead of cakes to be more directly relevant to finance, but the principle is the same. Suppose you believe the price of gold is going to increase in the next three months. You could enter into a forward contract to buy gold three months from now at a price agreed upon today, say $2000 per ounce. You are taking the long position.

As the buyer, or the party in the long position, your primary obligation is to purchase the agreed-upon asset at the predetermined future date and price. In our gold example, you are obligated to buy the gold at $2000 per ounce in three months, regardless of what the market price of gold is at that time. If the price of gold has indeed risen to $2200 per ounce, you are in a favorable position because you can buy it for the lower agreed-upon price. However, if the price of gold has fallen to $1800 per ounce, you are still obligated to buy it at $2000 per ounce. This is the inherent risk and potential reward in a forward contract for the buyer. Your obligation is to take delivery of the asset, in this case, the gold, and to pay the agreed-upon price, $2000 per ounce, on the specified future date. This commitment is binding. You cannot simply walk away from the deal without potential consequences, as forward contracts are legally enforceable agreements.

Now consider the bakery, or in our financial example, the seller of gold, taking the ‘short position’. Their primary obligation is to deliver the agreed-upon asset at the predetermined future date and price. If the bakery agreed to sell you a cake for $50 in three months, they are obligated to bake and deliver that cake at that price, even if the cost of ingredients goes up. Similarly, in our gold example, if the seller agreed to sell you gold at $2000 per ounce in three months, they must deliver the gold to you at that price, even if the market price of gold has risen to $2200 per ounce. Conversely, if the price of gold falls to $1800 per ounce, they are still obligated to sell it to you at $2000 per ounce. The seller’s obligation is to make available the asset, in this case, the gold, for delivery and to receive the agreed-upon price, $2000 per ounce, on the specified future date. Just like the buyer, this commitment is binding. The seller cannot simply decide not to deliver without facing potential legal repercussions.

In essence, both the buyer and the seller in a forward contract are locked into their respective sides of the agreement. The buyer is obligated to buy, and the seller is obligated to sell, at the agreed-upon terms on the specified future date. This mutual obligation is the core characteristic of a forward contract. It provides certainty about future price and delivery for both parties, which can be very valuable for planning and managing risk, whether you are securing ingredients for a bakery or hedging against price fluctuations in the gold market. It’s a direct and binding promise between two parties to exchange an asset at a future point in time for a price decided today.