Scribd
Upload
35 views

What Is A Forward Contract - Definition & Examples - Video & Lesson Transcript

A forward contract is an agreement between two parties to buy or sell an asset at a specified date in the future for a predetermined price. The purpose is either to hedge against risk or speculate. Settlement can occur through physical delivery of the asset or payment of the difference between the market and contract price. Examples include a farmer locking in the price of cattle sales months in advance through a forward contract, and a company hedging foreign exchange risk on a future international payment.

Uploaded by

veronica
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
35 views

What Is A Forward Contract - Definition & Examples - Video & Lesson Transcript

A forward contract is an agreement between two parties to buy or sell an asset at a specified date in the future for a predetermined price. The purpose is either to hedge against risk or speculate. Settlement can occur through physical delivery of the asset or payment of the difference between the market and contract price. Examples include a farmer locking in the price of cattle sales months in advance through a forward contract, and a company hedging foreign exchange risk on a future international payment.

Uploaded by

veronica
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 2

11/7/2019 What is a Forward Contract? - Definition & Examples - Video & Lesson Transcript | Study.

com

What is a Forward Contract? - De nition & Examples

Lesson Transcript

A forward contract is a popular investment tool used by large corporations and small investors alike. This lesson
de nes the term forward contract and explains its use through various examples.

De nition of a Forward Contract


In simplest terms, a forward contract is an agreement between two parties to buy or sell an asset
at a speci ed date in the future for a predetermined price. The reason for such an agreement is
either to hedge (enter into a transaction to reduce the risk of loss in another transaction) or to
speculate (create a transaction for which there is substantial risk but also the anticipation of gain).

Contract Settlement
Settlement of the forward contract can occur either on a cash or delivery basis. In addition to the
cash payment from the buyer, a contract made on a delivery basis will require the seller to supply
the asset to the buyer on the settlement date. A contract made on the cash basis, on the other
hand, merely requires a cash settlement between the buyer and seller on the settlement date. The
asset is never delivered to the buyer. The amount of the cash settlement is based on the di erence
between the current market price and the agreed contract price. If both the market and contract
prices are the same on the date of settlement, no money changes hands, and the contract is
closed.

Examples
One of the most common forward contracts involves the sale of a commodity. Suppose a cattle
farmer wishes to sell 100,000 cattle in six months. He wants to lock in the price now, so he enters
into a forward contract with his bank to sell 100,000 cattle in six months for $10 million. In six
months, cattle are plentiful and are selling for $90 per head on the open market. The 100,000 cattle
are only worth $9 million. Despite this, the bank has agreed to pay $10 million. If settlement is
made on the cash basis, the bank pays the farmer $1 million, which is the di erence between the
contract price of $10 million and the market price of $9 million. The farmer then sells his cattle on
the open market for $9 million to collect the full $10 million.

https://study.com/academy/lesson/what-is-a-forward-contract-definition-examples.html 1/2
11/7/2019 What is a Forward Contract? - Definition & Examples - Video & Lesson Transcript | Study.com

In another form, forward contracts are used to facilitate international trade. The increase in
international trade has created an enormous market for hedging with forward contracts for the
purpose of minimizing foreign exchange risk. Consider the following example of a foreign currency
forward contract.

American Company just sold 100 laptop computers to Spanish Company for 50,000 euros due in
three months. American Company is concerned about the devaluation of the euro from the current
date until the date payment is received. Therefore, American enters into a forward contract to sell
50,000 euros in three months. In this fashion, American Company locked in the exchange rate at
the time of the sale, despite the fact that the company will not receive payment for the laptops for
another three months.

An investor might also enter into a forward contract for speculation purposes. Consider the
American Company example. While American Company successfully hedged the risk of a devalued
euro, there must be a party willing to buy the euros to complete the hedger's transaction. This
party is often a speculator. This speculator is willing to buy the euros in the forward sale because
the speculator thinks the value of the euro will appreciate at some time in the future. This position
is more risky and requires extensive research on the part of the speculator.

Lesson Summary
A forward contract is a current agreement to purchase an item in the future at a price to be paid
in the future. The reason for entering into such a transaction is either to hedge or to speculate.
Hedging involves entering into a transaction to reduce the risk of loss in another transaction
Speculate involves creating a transaction for which there is substantial risk but also the
anticipation of gain. Settlement of the forward contract can occur either on a cash or delivery basis.

https://study.com/academy/lesson/what-is-a-forward-contract-definition-examples.html 2/2

You might also like