Forward Contract
Forward Contract
A forward contract is a customized legal agreement between two parties to buy or sell an Asset at a specified future date for a price that is agreed upon today. These contracts are typically used in the financial markets for Hedging or speculation purposes and are traded over-the-counter (OTC), meaning they are not standardized or regulated by an exchange.
Key Features
- Customization: The terms of a forward contract, including the price, quantity, and settlement date, can be tailored to the specific needs of the parties involved.
- Settlement: Settlement can occur either through physical delivery of the Asset or through cash settlement, where the difference between the agreed price and the market price at maturity is exchanged.
- Counterparty Risk: Since forward contracts are not traded on an exchange, there is a risk that one party may default on the contract.
Examples
1. Agricultural Forward Contract: A farmer agrees to sell 1,000 bushels of wheat to a miller at $5 per bushel, to be delivered in six months. This allows the farmer to lock in a price and the miller to secure a supply.
2. Currency Forward Contract: A company expecting to receive €100,000 in three months may enter into a forward contract to sell euros for US dollars at a rate of 1.10. This protects the company against unfavorable currency movements.
Cases
In 2008, a company involved in international trade entered a forward contract to hedge against fluctuations in foreign Exchange Rates. When the currency market moved unfavorably, the company was able to fulfill its obligations at the pre-agreed rate, avoiding significant losses.
In another case, a hedge fund entered a forward contract to buy oil at $70 per barrel for delivery in one year. If the market price rises to $90 at that time, the hedge fund can benefit by purchasing at the lower forward price.