Forward Contracts Definition in Finance: An Overview
Forward contracts are an essential financial instrument that enables buyers and sellers to lock in a fixed price for an asset or commodity at a future date. They are used to hedge against price fluctuations and uncertainties in the market. In this article, we will explore the definition of forward contracts, their features, and how they are used in finance.
What is a Forward Contract?
A forward contract is a legal agreement between two parties to buy or sell a specific asset at a predetermined price and date in the future. It is a non-standardized contract and, therefore, can be customized to meet the needs of the parties involved. The asset in question can be a commodity, currency, or financial instrument. The parties involved are generally institutional investors, corporations, or speculators.
Features of a Forward Contract
Forward contracts have several unique features, such as:
– Non-standardized: The terms of the contract are customized to meet the needs of the parties involved. There are no set contract sizes, expiry dates, or delivery dates.
– Private agreement: The contract is negotiated between two parties and is not traded publicly on an exchange.
– No upfront payment: There is no initial payment required to enter into a forward contract. However, the parties involved need to post margin or collateral to secure the contract.
– No daily settlement: Unlike futures contracts, there is no daily settlement of gains and losses. The gains and losses are settled at the end of the contract period.
– OTC settlement: The settlement of a forward contract occurs over-the-counter (OTC) between the parties involved.
How are Forward Contracts Used in Finance?
Forward contracts are widely used in finance for hedging purposes. They provide a means for buyers and sellers to manage price risks associated with their assets or commodities. For instance, a company that requires a specific commodity for its production process can enter into a forward contract with a supplier to lock in a fixed price and avoid price fluctuations.
Speculators also use forward contracts to profit from anticipated price movements. For example, a currency trader may enter into a forward contract to purchase a foreign currency in the expectation that its value will increase in the future.
In summary, forward contracts are a fundamental financial instrument used to hedge against price risk and uncertainties in the market. They are a private agreement between two parties and are non-standardized, meaning that their terms are customized to meet the needs of the parties involved. Forward contracts are widely used in finance by institutional investors, corporations, and speculators, and they provide a means for these parties to manage their price risks and optimize their financial performance.