Forward Contract
Candlefocus EditorA forward contract is a contractual agreement between two parties to buy or sell an asset at a specified price on a future date. These contracts are not traded on a centralized exchange, rather they are considered over-the-counter (OTC) instruments. This means they are customized to meet the specific needs of the two parties involved, including the type of asset, amount, and delivery date.
Forward contracts are used to hedge against a change in the price of an underlying asset or commodity. Although they do not provide the same protection as a regulated futures contract, they can still be helpful in buffering against price volatility. For example, a producer of agricultural products could enter into a forward contract with a user of the product to set a price for delivery on a certain date in the future. This will protect the producer from sudden drops in the price of the product, either due to poor harvests or unfavorable market conditions.
These contracts do not require any cash outlay by either party until the pre-agreed delivery date. However, the buyer and seller remain exposed to settlement and default risk. If one party fails to deliver the asset as specified in the contract, then the other party may suffer a loss as a result. In some cases, it may be necessary to obtain collateral from one of the parties to protect against this risk.
Forward contracts can be helpful in planning future cash flows and managing risks related to price volatility. The limitations of forward contracts, such as lack of liquidity and the potential for default, should be taken into consideration when deciding whether to enter into such an agreement. With that being said, forward contracts can be an effective way of hedging against price risk and managing cash flows.