Forward Contract and Future Contract forms are considered the two most essential products for Hedging. There are also linear derivatives as they follow a zero-sum game, i.e. profit of party A is the loss of party B.
A forward contract is a non-standardised contract between two counterparties without the involvement of an exchange. It refers to an agreement that specifies the price and quantity of an asset to be delivered sometime in the future.
In the forward contract, there is no standardisation.
Example of a Forward Contract:
Forward contracts are often used in foreign exchange situations as these contracts can be used to hedge foreign currency risk. Let's take an example of a currency forward where party A takes a long position in USD and party B takes a short position in JPY. One party takes a long position, agreeing to purchase the USD at a future date for a specified price, while the other party is short, agreeing to sell the JPY on that same date for that same price.
Why is Forward Contract important?
Forward contracts are considered one of the most widely used hedging products, especially in the currency market. Hence, risk managers must understand the forward contract well.