Forward contract: Overview, definition, and example
What is a forward contract?
A forward contract is a private, customizable agreement between two parties to buy or sell an asset at a specific future date for a price agreed upon today. Unlike standard market contracts, forward contracts are not traded on exchanges and are tailored to the needs of the involved parties. These contracts are commonly used for commodities, currencies, or financial instruments to hedge against price fluctuations or to speculate on future price movements.
Why is a forward contract important?
A forward contract is important because it provides both parties with price certainty and the ability to manage risk related to future price changes. By locking in a price for a future transaction, businesses or investors can protect themselves from volatility in the market. This can be especially valuable in industries where price fluctuations can have significant impacts, such as agriculture, energy, or finance.
Understanding a forward contract through an example
Let’s say a company, ABC Manufacturing, agrees to buy 1,000 barrels of oil from XYZ Oil Supplier in six months for $50 per barrel. The forward contract is signed today, locking in the price of oil regardless of how the market price changes in the future. If, in six months, the market price of oil has risen to $60 per barrel, ABC Manufacturing still pays the agreed-upon price of $50 per barrel, thus saving money.
In another example, a U.S. company that exports products to Europe might enter into a forward contract to exchange U.S. dollars for euros at a fixed exchange rate in three months. This helps the company lock in the rate and protect itself against potential changes in currency exchange rates that could affect the value of their revenue.
An example of a forward contract clause
Here’s how a clause related to a forward contract might appear in an agreement:
“The Parties agree to enter into a forward contract for the purchase of [Asset] at the price of [Price] per unit, to be delivered on [Date]. The agreed-upon price shall remain fixed regardless of any market fluctuations in the interim period.”
Conclusion
A forward contract is a useful tool for businesses and investors to lock in prices for future transactions, providing protection against market volatility and price uncertainty. By agreeing to a specific price today for a transaction in the future, parties can better plan for potential financial impacts and ensure they are not exposed to unfavorable price movements.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.