Derivatives basics
Forward contracts
3 min
A forward contract is the simplest derivative: a private agreement between two parties to buy or sell an asset at a fixed price on a fixed future date.
A worked example
A Brazilian exporter will receive US$1,000,000 in 90 days and fears the dollar weakening against the real. They enter a forward to sell those dollars at a locked rate of 5.20 BRL per USD.
Locked rate: 5.20 BRL/USD
Amount: US$1,000,000
Guaranteed BRL: R$5,200,000 in 90 days
No matter where USD/BRL trades in 90 days, the exporter receives R$5,200,000. The currency risk is gone.
The trade-offs
- Customizable. Amount, date and price are negotiated freely — forwards are tailored.
- Both sides are obligated. Unlike an option, neither party can walk away. If the dollar instead strengthens to 5.50, the exporter still sells at 5.20 and forgoes the gain. A hedge removes downside and upside.
- Counterparty risk. Because a forward is a private (OTC) deal with no clearing house, each side depends on the other actually honouring it. If the counterparty defaults, the protection evaporates.
That counterparty risk is exactly the problem futures were invented to solve.
This content is for educational and informational purposes only and is not investment, financial, tax or legal advice. Trading and investing carry risk, including the possible loss of capital. Any performance shown by third-party tools is hypothetical and not a promise of future results. Do your own research and consider professional advice before making any decision.