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What is the role of risk in forward contracts?

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cruth8646 | Student, Kindergarten | eNoter

Posted November 8, 2010 at 3:44 AM via web

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What is the role of risk in forward contracts?

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sociality | High School Teacher | Valedictorian

Posted November 8, 2010 at 3:48 AM (Answer #1)

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A forward contract is a customized agreement created between two parties in which the buyer agrees to buy from the seller, what is called the underlying asset at a future date. Each forward contract is specifically created between two parties and there exists a possibility of one of the parties defaulting. The forward market is a private and largely unregulated market. There are no rules or government regulations governing the contracts except terms which are included in the contract and which also specify how one party has to reimburse the other in case of a default. This is the primary reason behind forward contracts involving only large banks, financial institutions, governments, large corporations and the alike that can be trusted and with whom the risk of default is greatly reduced. Small entities are seldom parties in forward contracts.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted November 8, 2010 at 3:49 AM (Answer #2)

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In a forward contract, both parties assume a risk.  They are essentially betting against one another and so each has a risk of losing.

In a forward contract, one party, we'll call it Party A, agrees to deliver some amount of a good on some date in the future.  The other party (Party B) agrees to pay right now a certain price for those goods.  That is where the risk comes in.

On the date that Party A agreed to deliver the goods, the price of those goods might be higher or lower than the price that Party B paid.  If it is higher, Party A loses money and Party B profits.  If the price is lower, Party A gains and Party B loses.

So there is risk in a forward contract for both parties.

I should also say that forward contracts are often used to try to limit risk.  Parties want to have certainty about the price that they will get or pay.  For example, a farmer may want to enter into a forward contract so he does not have to worry about the price of the crop dropping.  He might not make as much as he could (if the price goes up) but at least he has a certain price locked in and has limited his risk of losing money if the crop's price drops.

So even though there is risk in a forward contract, they are often used as a way to limit other risk.

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