Forward contracts in financial management are agreements to buy or sell assets at a future date for a set price. They're used for hedging against price volatility in commodities, currencies, and interest rates. The valuation of these contracts depends on the spot price, risk-free rate, and time to maturity. They differ from futures in that they're not standardized and carry higher counterparty risk. Businesses benefit from the ability to tailor contract terms and manage risk without upfront costs.
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Forward contracts are over-the-counter agreements between two parties that allow for customization in terms of asset quantity, delivery date, and price
Forward contracts are primarily used for hedging purposes, allowing businesses to stabilize costs and revenues by locking in prices for commodities, currencies, and interest rates
Forward contracts carry significant counterparty risk since there is no central clearinghouse to guarantee the performance of either party
The forward price is determined using the formula F = S * e^(rT), where F represents the forward price, S is the current spot price, r is the risk-free interest rate, and T is the time to maturity
The value of a forward contract fluctuates based on changes in the spot price, risk-free rate, and time remaining until maturity
The present value of a forward contract is given by V = S * e^(-rT) - K * e^(-rT), where V is the present value, S is the spot price, r is the risk-free rate, T is the time to maturity, and K is the delivery price specified in the contract
Forward contracts serve as a strategic financial tool for managing price risk, allowing companies to secure future supplies at fixed prices and hedge against the risk of rising prices
The outcome of a forward contract, whether it results in a profit or loss, becomes tangible only at the contract's settlement date
Forward contracts do not typically involve any initial exchange of funds, making them a cost-effective hedging mechanism
Forward contracts are private, over-the-counter agreements with customizable terms, while futures contracts are standardized contracts traded on regulated exchanges with daily settlement and a clearinghouse to mitigate default risk
The flexibility of forward contracts allows for bespoke needs, while also offering cost efficiency and strategic planning without immediate concern for market conditions
Forward contracts carry the risk of counterparty default and the opportunity cost of missing out on favorable market movements
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Forward contracts differ from exchange-traded derivatives as they are not ______ and are negotiated directly between the involved parties.
standardized
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Characteristics of forward contracts
Traded OTC, customizable terms, not standardized like futures.
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Determinants of forward contract value
Spot price, risk-free rate, time to maturity, delivery price.
