A forward contract is a commonly used external forex risk management strategy which is basically an agreement which the buyer i.e. the importer and the seller i.e. the exporter enter into for trade of goods and assets. A forward contract takes place on a future date at a forward price and forward rate. A forward price or rate refers to the price of goods and assets or the rate of exchange decided today for the trade that is to take place in future. Oil, metals and grains are some common commodities that are traded internationally on the basis of such forward contracts. Today, trade of financial commodities also takes place in form of forward contracts. Such a contract has an advantage of being tailored according to the requirements of the parties involved in a Forward Contract. Thus, the document can be changed according to the needs and terms of agreement which takes place between the buyer and the seller.
Some of the variable factors that lead to such customization are delivery date, type of commodity being traded and the amount involved. As discussed earlier, a forward contract is a highly effective external tool to hedge and deal with the risk involved in a foreign exchange market. International trade transactions involve currency exchange and hence are affected to a great extent by the exchange rate fluctuations that are extremely dynamic and volatile. Using forward contracts fixes the exchange rate or exchange price for a future trade transaction, thus hedging the risk involved.
A forward contract is an Over the counter or OTC instrument and is not traded on a centralized foreign exchange. Long position and short position are two commonly used jargons in case of forward contracts. A long position is the position assumed by the buyer or the importer of commodity and short position is the position assumed by the exporter or seller.
Why are Forward Contracts important?
Forward contracts are highly effective and hence highly important. The main importance is for two types of parties in a foreign exchange market being the hedgers and the speculators. The hedgers are the people who basically are involved in international trade and thus want to hedge the risk associated with the transaction. They do not aim at earning any profits from forwards, their main target is to safeguard the transaction. The other party interested being speculators, who have the agenda of profit in mind. They speculate on the rates of exchange and the fluctuations of rates in the forex markets. They are not interested in trading of commodities. They simply place bets on the direction of prices and their movements and make predictions. Thus, forwards are attractive to both hedgers and speculators.
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