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Forward Contract and Hedging

Nagabhushan (Article Assistant) (50 Points)

26 October 2009

what is forward contarct and Hedging process..? if a co. wants to aviod the exchange risk how it can avoid the fluctuation risk by entering into forward contracts... Please explain me in breif..................

Thanks in advance..........

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4 Replies

CA Suri Kota (Assistant Manager @ EY) (955 Points)
Replied 26 October 2009

Its better to go through MAFA Books ...............there is a detaled notes of the concept.

Deeps (Article Assisstant) (2485 Points)
Replied 26 October 2009

A forward contract or simply a forward is an agreement between two parties to buy or sell an asset at a certain future time for a certain price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset 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. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not marked to market, exchange traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. A forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain.

satya prakash rawat (student) (36 Points)
Replied 26 October 2009

in laymen language if uwanna buy some item say dollar currency in futurend r not sure that how much will dollar cost in future {coz it may go upward or downward} so u make a contract wid the person who sells dollar to buy dollar for an agreed price.thts hedging. means u have safeguard against dollar fluctutaion in future wen u will be needing those.

SFM for CA Final (Director) (93 Points)
Replied 29 October 2009

Dear Nagabhushan,

A forward contract is an agreement to buy or sell an asset at a certain future time for a certain price.

Forward contracts on Foreign exchange are very popular.

For eg: On July 20, 2009, Finance Manager of X Ltd knows that the company has to pay $10 million in 6 months (i.e on Jan 20, 2010) and wants to hedge against exhange rate movements. Lets assume the 6 month forward rate for Rs./$ = 40. The FM can agree to enter into a 6 month forward contract to buy dollars at the exchange rate of Rs./$ = 40. Hence, 6 months later, irrespective of the future spot rate of Rs./$, the Company has sealed the rate at 40.

Forward contract do not guarantee profits however they can be used as instrument to reduce losses, thats what is popularly refered to as Hedging.