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Forward market hedging is a way of reducing the volatility in future profits by creating contracts in advance to buy or sell goods in the future.
Producers can predict with a fair amount of accuracy what their production in the future might be and the amount of raw material that they would require. An increase in the cost of raw material could adversely impact their revenues, so can a decrease in the selling price of what has been produced.
One of the ways of hedging this risk is with forward contracts. These are over-the-counter contracts created between a seller and a buyer to sell or buy a certain quantity of an asset at a certain price in the future. This eliminates the risk that may arise due to a change in price and also provide an assurance that a buyer or a seller will be available in the future.
For example, a farmer who grows wheat and a biscuit manufacturer can create a contract which specifies that in June the farmer will deliver 100 tons of wheat with a minimum 25% starch content to the manufacturer at $1 per kilogram. The contract could also include details like where the delivery has to be made, how the wheat has to be processed, who checks the quality, etc. By entering into such a contract, the farmer is assured of receiving $100,000 for the wheat that is grown by him irrespective of what the actual price of wheat in June is. The biscuit manufacturer is also assured of getting the wheat which is a primary component in making biscuits at the price that is mentioned in the contract.
Forward contracts are not traded in exchanges and are custom made. As there is no clearing house involved here, the chances of default are higher. This makes it essential to evaluate the ability of the opposite party to honor the contract and to introduce clauses in the contract to reduce the risk of default for both the parties.
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