A contract traded on markets to exchange a specific amount of a commodity at an agreed future price and at an agreed future time.  The party agreeing to buy the commodity is said to have a long position, while the seller has a short position.  Forward contracts are similar to futures contracts in that both specify the exchange of goods for a specified price at a specified future date.  However, a forward contract is not traded on an exchange and the subject of a forward contract is not standardised.  Both approaches may be used in hedging, as these transactions allow speculators and purchasers to adopt an investment position intended to offset potential losses that may be incurred in the acquisition of the commodity.

For example, a chocolate manufacturer may enter into a contract to buy cocoa to make chocolate.  The contract is for 1000kg of cocoa to be delivered in three months time at a price of $1 per kg.  In three months time the price of cocoa may be more or less than $1 per kg, exposing the manufacturer to risk, so they may hedge the purchase by agreeing to sell 1000 kg of cocoa for $1 per kg in three months time.

If in three month’s time the spot price of cocoa is $2 per kg, the chocolate manufacturer will make a $1000 profit on their purchase of cocoa, as they can buy at $1 per kg rather than the spot price of $2 per kg.  However, they have to buy 1000kg of cocoa on the open market at $2 per kg to fulfil their obligation to sell 1000kg of cocoa at $1 per kg, resulting in a loss of $1000; exactly what they made on the purchase.

Similarly, if the spot price of cocoa is $0.50 per kg in three months time, the manufacturer will lose $500 on the purchase element of the hedge, but can buy cocoa at half the price it has agreed to sell at, making a profit of-$500.  See also Hedging.