Forward contracts are a type of derivative in banking that allows two parties to enter into a legally binding agreement to buy or sell an asset at a predetermined price and date in the future. These contracts are traded in over-the-counter (OTC) markets and are customized to meet the specific needs of the parties involved.
Forward contracts are usually used to hedge against potential price fluctuations or to speculate on the future price movement of an underlying asset. They are common in the foreign exchange market, where companies use them to hedge against currency risk. For example, a company that expects to receive a payment in a foreign currency at a future date may enter into a forward contract to sell that currency at a fixed rate, thereby reducing its exposure to currency fluctuations.
The main advantage of forward contracts is that they are customizable, which means that parties can agree on the specific terms and conditions of the contract to suit their particular needs. However, the lack of standardization means that forward contracts are not traded on exchanges and are therefore subject to counterparty risk. This is the risk that the other party to the contract may default on their obligation to buy or sell the asset, which could result in financial losses for the other party.
In order to mitigate counterparty risk, parties to a forward contract often require collateral or a guarantee from a third-party intermediary such as a bank or clearinghouse. Additionally, parties may choose to use a futures contract instead of a forward contract. Futures contracts are similar to forward contracts, but are traded on exchanges and are standardized, which reduces counterparty risk.