A forward hedge is an agreement between buyers and sellers to purchase assets or commodities at a fixed price in the future. The seller must produce the desired quantity, even if they have a short supply, and may need to hedge additional units to meet the terms of the forward option. There are risks associated with future coverage, and buyers and sellers should project the price movement in the market to manage a forward hedge if necessary.
A forward hedge is a type of bond that allows buyers and sellers to enter into an agreement to purchase assets or commodities at a fixed price at a future date, with details of the price and quantity that will be purchased. As part of the agreement, the seller must produce the desired quantity, even if he has a short supply when the purchase date arrives. In other words, the seller may need to hedge addition units to meet the terms of the forward option, with the additional assets constituting a cover.
One of the easiest ways to understand how forward hedging works is to consider an investor who opts into futures to buy 25,000 bushels of soybeans, with the date of purchase and delivery expected to be three months in the future. The seller agrees to the terms, essentially making a pact to deliver all 25,000 bushels by the agreed date, subject to receiving payment from the buyer. If the seller finds that he only has 20,000 bushels to fulfill the terms of the sale, he will need to buy another 5,000 bushels for immediate delivery in order to settle the transaction. These 5,000 bushels would be called front cover.
The front cover concept also has some impact on the buyer. Just as the seller undertakes to deliver the agreed quantity by the specified date, the buyer undertakes to provide payment in full by that date. This means that even if the buyer does not have the cash on hand to honor the deal, he will need to liquidate assets or borrow funds to complete the transaction, with the borrowed funds constituting a hedge.
In the best of situations, there is no need for forward coverage. The seller has enough in stock to complete the transaction without the need to secure additional amounts elsewhere. Likewise, the buyer has the financial resources available to pay for the order without the need to obtain additional funds from an outside source. When the buyer can use the futures contract to buy the goods at a price below the current market value on the delivery date, he can sell the goods immediately and make a profit on the transaction. At the same time, the seller didn’t have to worry about finding buyers, and presumably secured a futures contract price that was enough to cover all expenses and make some sort of profit.
There are risks associated with future coverage. Sellers can end up losing money on the transaction if additional units need to be purchased at prices much higher than the agreed unit price in the future sale. Buyers can also lose money if products are being sold in the market for less than the agreed purchase price. For this reason, the buyer and seller should take the time to project the price movement in the market between the date the transaction is completed and the futures contract settlement date, making it easier to manage a forward hedge if necessary. . .
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