A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. It is an agreement that takes place in an over-the-counter (OTC) market. This type of contract is recognized as a private deal agreed upon by both parties involved. This also means that the terms for a forward contract such as quantity, price, and delivery date, are open for customization. Dealing directly in an OTC market, parties are more prone to counterparty risk, that is, the risk that the counterparty will be unable to meet the terms of the contract. Forward contracts are commonly used in businesses for hedging risk associated with prices or to take advantage of anticipated price changes.
Related Questions
1. Are forward contracts exchange-traded?
No, forward contracts are traded over-the-counter (OTC) which means the terms of the contracts can be tailored to fit the specific needs of the buyer and seller. They do not take place in a centralized exchange.
2. How is a forward contract different from futures contracts?
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While both forward contracts and futures contracts allow the purchase or sale of an asset at a specific time, there are key differences. Forward contracts are privately traded, customizable and thus more flexible, however, they also expose the parties to greater counterparty risks. Futures, on the other hand, are standardized contracts traded on an exchange and have less counterparty risk.
3. What is the purpose of a forward contract?
The main purpose of a forward contract is to hedge against potential risks associated with price fluctuations. It enables buyers and sellers to set a specific price for an asset, thus ensuring stability despite asset price changes in the market.
4. Who uses forward contracts?
Typically, forward contracts are used within the financial and commodities industries. For example, farmers, oil refineries, and global money managers find them helpful in mitigating risk related to price unpredictability.
5. Can a forward contract be cancelled?
A forward contract can’t be cancelled outright. However, it can be closed by setting up a separate offsetting contract. This new contract should have the same terms but opposite position to the original contract. This approach effectively neutralizes your obligation under the original forward contract.