Forward Agreement Example: Understanding the Basics

Forward agreements are commonly used in financial markets to hedge against future risks. In this article, we will explore what a forward agreement is, how it works, and provide an example of a forward agreement to help you better understand its mechanics.

What is a Forward Agreement?

A forward agreement is a contract between two parties to purchase or sell an underlying asset at a predetermined price (also known as the forward price) at a future date. The underlying asset can be anything from commodities, currencies, stocks, or even real estate. The parties involved in the contract agree on the terms and conditions of the agreement, including the price, quantity, and delivery date.

How Does a Forward Agreement Work?

A forward agreement works like any other futures contract, with the main difference being that it is an over-the-counter (OTC) agreement between the buyer and the seller. This means that the contract is customized to meet the specific needs of the parties involved, rather than being a standardized contract traded on an exchange.

When a forward agreement is initiated, the buyer and seller agree on the terms and conditions of the contract, including the price, quantity, and delivery date. The buyer agrees to purchase the underlying asset from the seller at the forward price on the delivery date. The seller agrees to deliver the underlying asset to the buyer on the delivery date, at the agreed-upon forward price.

Example of a Forward Agreement

Let`s say that Company A is a manufacturer of widgets, and it requires a particular raw material to produce its widgets. Company B is a supplier of this raw material and wants to lock in a price for its product to ensure that it doesn`t lose money due to market fluctuations.

Both companies enter into a forward agreement, where Company A agrees to purchase a specific quantity of the raw material from Company B at a future date, say six months from now, at a predetermined price of $10 per unit. The forward agreement is customized to meet the needs of both companies, and they both agree to the terms and conditions of the contract.

Six months later, the price of the raw material has gone up to $12 per unit. However, as per the forward agreement, Company B is obligated to deliver the raw material to Company A at the pre-agreed price of $10 per unit. Company A benefits from this agreement because they locked in a lower price for the raw material, irrespective of any subsequent price increases. Company B also benefits from this agreement because it has certainty regarding future cash flows.

Final Thoughts

In conclusion, forward agreements are an essential tool for businesses to hedge against future risks. The ability to customize these contracts to meet the specific needs of the parties involved provides a valuable source of flexibility. By understanding the mechanics of forward agreements and using them effectively, businesses can protect themselves against future uncertainties and promote financial stability.