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Forward contract

Forward Contract

A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date and price. Unlike standard futures contracts, forward contracts are not traded on exchanges and are often used for hedging or speculative purposes. They are tailored to the needs of the parties involved, allowing for flexibility in terms, quantities, and settlement. Forward contracts carry counterparty risk, as there is no clearinghouse guaranteeing the transaction.

Example

A wheat farmer enters into a forward contract with a buyer to sell 1,000 bushels of wheat at $5 per bushel six months from now, protecting against future price declines.

Key points

• Customized agreements for future purchase or sale of an asset.

• Used for hedging against price movements or for speculative purposes.

• Not standardized or exchange-traded, carrying counterparty risk.

Quick Answers to Curious Questions

How do forward contracts help businesses manage price risk?

They lock in prices for future transactions, protecting against adverse price movements and stabilizing cash flows.

What are the main differences between forward and futures contracts?

Forwards are private, customized, and carry counterparty risk, while futures are standardized, traded on exchanges, and backed by clearinghouses.

What risks are associated with forward contracts?

Counterparty risk is significant, as one party may default, and market risk remains if prices move unfavorably relative to the agreed-upon terms.

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