What is a forward contract?

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A specific agreement between two parties to acquire or sell an item at a predetermined price at a later date is called a forward contract. This kind of contract can be used for speculation or hedging, but because of its non-standardized structure, it’s best for hedging.

A forward contract, unlike a typical futures contract, can be designed for a particular product, price, and date of delivery. Precious metals, grain, oil, natural gas, and even poultry are all examples of commodities that can be traded. A forward contract might be settled in cash or in the form of delivery.

Forward contracts are considered over-the-counter instruments since they are not traded on a centralized exchange. While the lack of a centralized clearinghouse makes it easier to personalize terms, it also raises the risk of default.

If a person prefers certainty, the forward contract provides it as an obvious advantage. The value of the dollar fluctuates due to a wide range of variables. On higher quantities, even a fraction of a percentage point variation in the exchange rate can make a significant difference. If someone is placing a large purchase from an international supplier or has long-term commitments in another country, a forward contract allows them to keep expenses under control.

Currency, on the other hand, fluctuates in both directions: a forward contract protects a firm if the value of the dollar falls, but it also has the potential to rise. A person may be caught at a lower rate than the market rate if the dollar increases.

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Pieter Borremans
By Pieter Borremans

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