A forward contract primarily is a sort of agreement between the buyer and seller or the importer and exporter of an asset or goods for business. In this kind of a contract the price is decided for a particular day in future. Thus, future price of goods is decided today between the two parties. There are a number of goods and assets that can be traded under such type of a contract some of them being oil, grains and metals. Trade of financial instruments is no exception to such a contract. A forward contract has a big advantage that it is customized document that can be altered and changed according to the needs and the terms of agreement between the two parties. Some of the factors that influence customization of forward contracts is the delivery date, the commodity being traded and the amount being dealt in. A forward contract is a popular external tool to hedge and deal with the risk faced in the foreign exchange markets. Transactions in which the goods and compensation for the goods is to be exchanged on a future date is affected to a major extent by the exchange rate fluctuations and have a great amount of risk involved. Use of forward contracts is a great instrument to deal with this risk by fixing the price today. The date at which the trade has to take place is known as forward date and the price for the asset or commodity is known as the forward price.
A forward contract is an OTC instrument or an over the counter instrument which is generally not traded on a centralized exchange. There are two terms linked with forward contracts: long position and short position. The party in the transaction which buys the asset or the commodity is known to assume a long position and the seller’s position is known to be a short position.
Why are Forward Contracts important?
Forward Contracts are considered relevant for two types of participants in a foreign exchange market. These two participants are hedgers and speculator. Hedgers are the people who use forward contracts to stabilize their business operations by stabilizing the costs and revenues of the business. Profit is not their objective of entering into forward contracts. Since profit isn’t the agenda their gains or losses are negligent and in case a profit or loss occurs it is nullified by a loss or profit that occurs in the market where the asset or the commodity is being traded. On the other hand, there are speculators. Speculators are not concerned with stabilizing a business or trade their main agenda of entering into a forward contract is to make profit. The speculate on the exchange rates and their fluctuations in the foreign exchange markets. They do not deal in any asset and are not interested in buying or selling any asset or commodity, speculators actually place bets on the direction of price movements of the assets and make predictions. Their main focus is the profit in dealing.
Forward contracts are safe tools and hence are more attractive for hedgers than for speculators.
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