Sell Forward Contract: Everything You Need to Know
A sell forward contract is a type of financial instrument used in a risk management strategy for the purpose of hedging.3 min read
A sell forward contract is a type of financial instrument used in a risk management strategy for the purpose of hedging. The buyer and seller are in agreement on forward contracts. In this type of agreement, the seller and buyer commit to a specific price for exchanging a commodity at a date in the future.
An investor sells forward on the belief that either a security's price or the demand for it are going to drop. This helps the investor cut his or her losses because the item in question is being sold now before the price drops, instead of later after it has been lowered.
Farmers and Investors
Farmers and investors are examples of people who commonly enter forward contracts. Investors use forward contracts to buy and sell foreign commodities, like oil or another country's currency. This is done for hedging or speculation, but it's more common for hedging due to its non-standard qualities.
In these situations, the forward contracts are agreements to provide payment for a delivered commodity. The forward contract language usually includes information about how the commodity will be delivered and what quality is acceptable. The forward contract settlement date is the date the buyer must pay for the commodity.
No Broker Required for a Sell Forward Contract
A forward contract differs from a futures contract because no broker is required. In a forward contract, the buyer and seller are:
- Making an agreement that locks in rates now for future revenue.
- Establishing a price now to plan ahead, this lets them know they're protected if rates drop and also know now how much they'll be getting.
- Locking in rates, so they don't have to worry about price drops.
Forward Contracts Have the Advantage of Simplicity
Unlike more complex types of transactions, forward contracts aren't traded in organized marketplaces. Full transparency is also beneficial when entering into forward contracts. At minimum, pricing information should be available to each party involved in the transaction. There's a chance one party may try to back out of the transaction or even completely default, but because a forward contract is legally binding, it's hard to break.
Risk Reduction With a Sell Forward Contract
Minimizing risk is the main reason to enter a forward contract; it reduces the likelihood of a negative fluctuation in a commodity's price. By offering a guaranteed price, the forward contract seller sets a firm price. The price a commodity might sell at in the future is called the spot price. Farmers and other producers of commodities try to predict how the spot price may compare to the current price.
The person buying the forward contract may be predicting the commodity's price will rise by the delivery date, and by agreeing to a price now, is trying to lock in the lower price. These contracts have the potential to impact a local market or even a regional one for a specific type of product.
Common Characteristics of Forward Contracts
There are some things that are common characteristics of forward contracts:
- Forward contracts are provided by commercial banks.
- Forward contracts are non-standard in amount, so you can set them up for any amount desired. This compares to standard amounts, such as only being able to buy in multiples of $100,000.
- The contract indicates the obligation to buy or sell at the time specified, in the amount specified, as detailed in the forward contract.
- You can't trade forward contracts.
The fact that forward contracts are not standardized in amount and are obligatory in nature makes them an efficient way to deal with import/export commodities because any amount can be used in the deal and the accounts receivable or payable information can be expressed in any form of foreign currency.
Accounting and Currency Exchange
Another advantage for businesses is that the accounting departments know the amounts for the accounts receivable and accounts payable beforehand, which adds to the simplicity of establishing a binding contract. If you're selling your commodity in another country, your customers will be paying you in their currency rather than US dollars, so you'll need to need that income moved back to your home country and exchanged to US dollars.
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