A forward contract is a financial agreement between two parties to buy or sell an asset at a predetermined price and time in the future. This contract is a non-standardized agreement and can be customized according to the needs of the parties involved.
For instance, let`s say a farmer wants to sell his wheat crop to a bakery six months from now. He is concerned about price fluctuations and wants a guaranteed price for his wheat, so he enters into a forward contract with the bakery. The parties agree that the bakery will pay $5 per bushel of wheat, and the farmer will deliver 1,000 bushels six months later, regardless of the market price at that time.
In essence, the forward contract allows both parties to lock in a price and reduce their risk of price volatility. The farmer is assured of a fixed price for his wheat, while the bakery knows exactly how much it will pay for the wheat and can plan accordingly.
Forward contracts are commonly used in commodity markets, such as agriculture, energy, and metals. They are also used in currency markets to hedge against foreign exchange risk, as well as in stock markets for the purchase or sale of shares.
It is important to note that forward contracts are not traded on exchanges and are not regulated by any specific authority. Therefore, there is a risk of counterparty default, which means that one of the parties may fail to fulfill their obligations under the contract. To mitigate this risk, parties usually involve a trusted intermediary, such as a bank, to act as a guarantor for the transaction.
In summary, a forward contract is a customized agreement between two parties to buy or sell an asset at a fixed price and time in the future. It is a useful tool for reducing price volatility and managing risk in various markets. However, parties should be aware of the risk of counterparty default and take appropriate measures to mitigate that risk.