NISM-Series-VIII: Equity Derivatives · Introduction to Forwards and Futures

Forward Contracts and Their Limitations Explained

Updated 11 October 2026 · Fact-checked

A forward contract is a customised over-the-counter agreement between two parties to buy or sell an asset at a fixed price on a fixed future date. Its main limitations are counterparty default risk, illiquidity, lack of standardisation and difficulty in finding a matching party. In exams, link each limitation to a feature.

Understand Forward Contracts and Their Limitations

A forward contract is an agreement made today to buy or sell an asset on a future date at a price fixed today. The buyer is the long party. The seller is the short party. The fixed price is the forward price (also called the delivery price).

Forwards are customised and traded over the counter (OTC). The two parties negotiate the asset, quantity, price, delivery date and place of delivery directly. There is no exchange and no clearing corporation in between. Usually nothing is paid upfront, and the contract is settled on the maturity date.

Example: an exporter expects to receive US dollars in three months. She agrees with a bank today to sell the dollars at a fixed rupee rate. Whatever the market rate is later, she gets the agreed rate. This removes her uncertainty, but also her chance of gain if the dollar rises.

The flexibility has a cost. Because each forward is private, it carries these limitations:

Counterparty risk (default risk): the other party may fail to honour the contract. Nobody guarantees performance.
Illiquidity: the contract is tailor-made, so it is hard to find someone to take over your position before maturity. Exiting early usually means a negotiated cancellation with the same counterparty.
Lack of standardisation: terms differ for every contract, so there is no common market price or lot size.
Search cost and lack of transparency: you must find a party with an exactly opposite need. Prices are not publicly disclosed and there is little regulation of the terms.

Exchange-traded futures were developed to remove these drawbacks by standardising contracts and adding a clearing corporation.

Key formulas to remember

Payoff to long forward at maturity: Payoff = Spot price at maturity − Forward price; Positive if spot ends above the forward price. Per unit of the asset.
Payoff to short forward at maturity: Payoff = Forward price − Spot price at maturity; It is the exact opposite of the long payoff. One party's gain equals the other's loss.
Core features of a forward: Customised + OTC + bilateral + settled at maturity + no clearing guarantee; Use this checklist to judge any statement in an MCQ.
Main limitations: Counterparty risk, illiquidity, no standardisation, search cost; Remember these four. Each follows from the contract being private and customised.

How to solve Forward Contracts and Their Limitations questions

Use this method for any question on forward contracts, their features or their limitations.

1Identify what is asked: a definition, a feature, a limitation, a comparison with futures or a payoff.
2Check the key words in the question: customised, OTC, bilateral, no exchange, no clearing corporation point to a forward.
3If it asks for a limitation, link it to its cause: private contract means counterparty risk; customised means illiquidity and no standardisation.
4If it asks for a comparison with futures, go feature by feature: terms, venue, guarantee, liquidity, margin, settlement.
5For a payoff question, decide who is long and who is short, then compute spot at maturity minus forward price for the long.
6Reverse the sign for the short party and confirm the two payoffs add to zero.
7Eliminate options that attribute futures features (standardised, exchange-traded, margins, clearing corporation guarantee) to forwards.

Quickest way: Customised and private means weak on safety and exit

When to use it: Use it for statement-type MCQs asking which feature or limitation belongs to a forward.

Ask: is this feature about flexibility or about safety and exit?
Flexibility (tailor-made terms, any asset, any date) is a forward's strength.
Safety and exit (default risk, hard to square off, no common price) are its limitations.
Pick the option that matches, and reject any option giving a forward an exchange or clearing guarantee.

Common mistakes in Forward Contracts and Their Limitations

Saying forwards are traded on exchanges.
Forwards and futures sound alike and both fix a future price.
Fix: Forwards are OTC and bilateral. Only futures are exchange-traded and standardised.
Believing a clearing corporation guarantees a forward.
Students carry over the futures feature of novation and guarantee.
Fix: A forward has no central guarantee. That is exactly why counterparty risk exists.
Treating customisation as a limitation.
The word sounds like a problem, but it is the main advantage.
Fix: Customisation is a strength. Its side effects, illiquidity and no standardisation, are the limitations.
Assuming margins are always paid in a forward.
Students confuse it with daily margining in futures.
Fix: Forwards typically have no daily mark-to-market margining. Any collateral is a matter of private agreement.
Mixing up the long and short payoff signs.
Students memorise one formula without linking it to the position.
Fix: Long gains when spot at maturity is higher than the forward price. The short gets the opposite.

Worked examples

Example 1

A jeweller agrees today to buy 1 kg of gold from a bullion dealer in three months at ₹70,00,000 per kg. On the delivery date, the market price is ₹72,50,000 per kg. Find the payoff to each party, and name the main risk the jeweller faces if the dealer refuses to deliver.

Show the solution

The jeweller is the buyer, so he is long. The dealer is short.
Long payoff = spot at maturity − forward price = ₹72,50,000 − ₹70,00,000 = ₹2,50,000.
Short payoff = forward price − spot = ₹70,00,000 − ₹72,50,000 = −₹2,50,000.
The two payoffs add up to zero, which confirms the calculation.
If the dealer refuses to deliver because he is losing, the jeweller faces counterparty (default) risk, since the OTC forward has no clearing guarantee.

Answer: The jeweller gains ₹2,50,000 and the dealer loses ₹2,50,000. The jeweller faces counterparty risk.

Example 2

Which of the following is a limitation of a forward contract? (A) Terms can be tailored to the needs of the parties (B) Risk of default by the counterparty (C) Daily mark-to-market settlement (D) Guarantee by a clearing corporation

Show the solution

Option A is customisation, which is an advantage of a forward, not a limitation.
Option C describes daily margining, which is a feature of futures, not forwards.
Option D describes the guarantee given in exchange-traded contracts, not forwards.
Option B follows from a private contract with no guarantor, so it is a real limitation.

Answer: (B) Risk of default by the counterparty.

Exam tips

Expect statement questions asking which feature belongs to forwards and which to futures. Learn the contrast pairs: OTC and exchange, customised and standardised, bilateral and guaranteed.
A common trap gives a forward a futures feature such as daily margining or a clearing corporation guarantee. Reject it.
Wrong answers cost marks in this paper, so if you cannot tell between two options, test each against the words customised, private and no guarantee before guessing.
For payoff sums, write down who is long first. Most errors come from reversing the sign.

Practice questions from Introduction to Forwards and Futures

Forward Contracts and Their Limitations in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Forward Contracts and Their Limitations: frequently asked questions

What is a forward contract with an example?

A forward contract is a customised OTC agreement to buy or sell an asset at a fixed price on a future date. For example, an importer agrees with a bank to buy dollars in three months at a rate fixed today. The rate stays fixed whatever the market does.

What are the limitations of forward contracts?

The main limitations are counterparty default risk, illiquidity, lack of standardisation and the difficulty of finding a matching party. Prices are also not transparent, since the deals are private.

What is the difference between forward and futures contracts?

A forward is customised, traded OTC and carries counterparty risk. A futures contract is standardised, traded on an exchange and guaranteed by a clearing corporation. Futures also involve margins and daily settlement of gains and losses.

Is a forward contract asked in the NISM Equity Derivatives exam?

Yes, it is part of the introductory material on derivatives. Questions usually test features, limitations and the contrast with futures, so learn these points precisely.