How Forward Contracts Work

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The nature of forwards as derivative securities is such that they can be employed to hedge against risk particularly in relation to currency or exchange rate risk.

Unlike in the case of a spot contract which involves mutual agreement between persons with a view to purchase or sell an asset on the same day, a forward contract deals with the same, on the basis of a future date.

Ordinarily, to assume a long position in these type of arrangements, an involved party has to elect purchasing an underlying asset at a date set sometime in the future, while the opposite (selling) translates to a short position.

On the other hand, currency forwards entail a single party initiating a forward contract with the intention of buying or selling a currency. The contract thereto typically demands such a transaction to be effected prior to the expiry date set in the future.

Due to the nature of currency dynamics, that are influenced by other forces or elements such as exchange rate fluctuations, parties to the currency forwards naturally aim to limit the period of exposure, and hence the expiry date.

If the exchange rate of the currencies concerned fluctuate between the trade date and the earliest date at which the contract is concluded or the expiration date, a single party profits while the counterparty turns a loss since only one currency appreciates against the other.

Whenever parties set a price and agree to carry the agreement forward, the stipulated monetary value is referred to as the delivery price, and is generally equivalent to the forward price at the point the contract is initiated.

The notional amount or reference amount may be the cost or margin requirement to command or open such a contract, and is considerably less that amount which refers to the leverage created, which is typical in derivative (finance) contracts.

Spot-forward parity renders a connection between the spot market and the forward market, by outlining the link between the spot and forward price of the underlying asset in a forward contract.

The spot forward parity has the qualities of an investment asset, and some consider it to be a consumption asset, with which they maintain for consumption purposes be it in oil or other commodities.

By their very nature, consumption assets come in the form of raw material commodities and are usually held in stock unlike in the case of forwards which basically maintain an asset. Commodities offer investors a strong benefit as regards value, and thus most people are prepared to keep them as inventory.

 

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