In this article, I will introduce a financial derivative called Forward Contracts. What are forward contracts? Forward contracts are used by companies to take advantage of a speculation.
A forward contract is an agreement between two parties to buy or sell a specific asset at a certain future time for a certain price agreed today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.
So how does forward contracts work? Forward contracts are some of the reasons why do some companies failed and declared bankruptcy. One example of an asset that is most transacted in forward contracts is oil. Oil is essential because it is one of the important raw materials to operate almost all types of machines. Companies use these machines and equipments in their operations. Therefore, when the price of oil rises, the tendency is that the price of their product will also rise.
So what do these companies do? They usually enter into a forward contract with oil suppliers. Speculating that the oil will rise in the next few months, they will sign forward contracts with these oil suppliers to supply them oil in a specific time in the future. These companies will benefit if the price of oil indeed rise. However, in contrast, if the price of oil fell, then they are at a loss since they are obliged to buy it at a much higher price than the market price.
Another example of where forward contracts are used is the foreign exchange. Foreign currency traders use forward contracts to leverage the rise and fall of currency values. Currencies are most important for traders and businessmen doing import and export of their products.