A Business Encyclopedia

Risk Hedging with Forward Contracts

Definition: The Forward Contract is an agreement between two parties wherein they agree to buy or sell the underlying asset at a predetermined future date and a price specified today. The Forward contracts are the most common way of hedging the foreign currency risk.

The foreign exchange refers to the conversion of one currency into another, and while dealing in the currencies, there exist two markets: Spot Market and Forward Market. The Spot market means where the delivery is made right away, while in the forward market the payment is made at the predetermined date in the future.

In the spot market, the rate is the current rate, which is prevailing at the time the currencies are being exchanged. Whereas, the rate in the forward market is the rate which has been fixed today or at the time the transaction is agreed to but the actual delivery takes place at a specified date in the future. Thus, forward currency contracts enable the parties to the contract to lock the exchange rate today, to buy or sell the currency on the predefined future date.

The party who agrees to buy the underlying asset at a specified future date assumes the long position, whereas the seller who promises to deliver the asset at a rate locked today assumes the short position. In a forward currency contract, the buyer hopes the currency to appreciate, while the seller expects the currency to depreciate in the future. Thus, the gain and loss of the buyer can be calculated as follows:

Gain = Spot Rate– Contract Rate
Loss = Contract Rate – Spot Rate

Where, the spot rate is the actual rate prevailing at the future date while the contract rate is the rate which was locked at the time transaction was agreed upon.

The forward contracts are similar to the options in hedging risk, but there is a significant difference between these two. The parties to the forward contracts are obliged to buy or sell the underlying securities at a specified date in the future, whereas in the case of the options, the buyer has the right to whether exercise the option or not. The other difference is that the forward contracts do not require any upfront payment in the form of premium which is very much required when buying the options contracts.

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