Forward agreement definition: Understanding this financial instrument
A forward agreement is a type of financial instrument that is commonly used in finance to lock in the price of an asset at a future date. It is an agreement between two parties – the buyer and the seller – where the buyer agrees to purchase a specific asset from the seller at a predetermined price (or rate) and at a specified time in the future.
The forward agreement is an important tool for investors, traders, and businesses who want to hedge against potential price fluctuations in the asset`s market. This can help them reduce their risk exposure and ensure that they know the exact price they will pay or receive for the asset in the future, mitigating uncertainties.
How does a forward agreement work?
A forward agreement requires both the buyer and seller to agree on the asset, price, and delivery date. The asset can be anything that has a value, such as a commodity, currency, or security.
For example, let`s say a coffee roasting company wants to purchase coffee beans from a coffee farmer. The company is concerned about the potential increase in the coffee price, so they enter into a forward agreement with the farmer. The agreement states that the farmer will sell 10,000 pounds of coffee beans to the roasting company in six months at a fixed price of $5 per pound.
If the coffee price increases to $6 per pound in the next six months, the company will still pay the farmer $5 per pound as per the agreement. The farmer, on the other hand, will secure the sale of the coffee beans at a fixed price, even if the market price falls below $5 per pound, ensuring that they have a guaranteed income.
However, it is important to note that forward agreements are not traded on exchanges, and are often bespoke contracts that are tailored to the specific needs of the parties involved.
Types of forward agreements
There are two types of forward agreements that are commonly used in finance – deliverable and non-deliverable forwards.
Deliverable forward agreements involve the actual delivery of the asset at the agreed-upon time. As per the example above, the coffee beans would be physically delivered to the roasting company.
In contrast, non-deliverable forwards are agreements in which the asset is not physically delivered, or the parties involved do not intend for the asset to be delivered. Instead, the buyer and seller settle the difference between the agreed-upon price and the market price on the delivery date.
Conclusion
A forward agreement is a useful tool to mitigate price risk, and it allows the parties to lock in a price for a particular asset to be delivered in the future. It is important to understand the terms and conditions of the agreement to minimize uncertainties and avoid any potential discrepancies or disputes between the parties involved.