What is Forward Contract? How To Hedge Risk Using Forward

forward contract

What is Forward Contract?

Forward Contract is an agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is agreed upon today.

Forward contracts are flexible. They are tailor made to suit the needs of both buyers and sellers. One can enter into forward contract for any goods, commodities or assets. In addition to this, you can also decide the date of delivery for any given quantity of assets. The most prominent condition to enter into this type of contract is that there must be a willing buyers and seller who are ready to enter into contract with each other.

Though there are various types of forward agreements such as goods, commodities or assets, but the foreign currencies forwards have the largest trading market. In addition to this, forward contracts are very much similar to option in hedging risk. There is just a hairline difference between the two. In case of a forward contract , contract binds both the buyer and seller. The buyer must take the delivery and seller must make the delivery on the price agreed. However, in case of option, buyer has the right to decide whether, he or she would exercise the option.

How to Hedge Risk using Forward Contracts?

Tata Motors has ordered a machinery from UK. The price of $200,000 to be paid after 3 months. The prevailing exchange rate is Rs 50.75. At the current exchange rate, the company would need 50.75 ×200,000 = 10,150,000. However company is expecting the depreciation of rupee when payment is made after 3 months. This will result in increasing the cost for the company. The question arises, what should company do?

Well, the answer is very simple, company can lock in the exchange rate by entering into forward contract and become tension free about fluctuations in the rupee. Now suppose the 3-month forward exchange rate is 50.95. The company can buy dollar forward. At the due date, the company will exchange 10,190,000 for buying $200,000.

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