A forward hedge is an agreement between buyers and sellers to purchase goods or assets at a fixed price on a future date, with specifications on both price and quantity. The seller must produce the desired quantity, even if they are short, and the buyer must provide full payment. The front cover is the additional amount needed to satisfy the terms of the forward option, and there are risks associated with upfront coverage.
A forward hedge is a type of obligation that allows buyers and sellers to enter into an agreement to purchase goods or assets at a fixed price at a future date, with specifications on both the price and quantity that will be purchased. As part of the deal, the seller must produce the desired quantity, even if he is short of that amount when the purchase date arrives. In other words, the seller may have to guarantee the units of addition in order to satisfy the terms of the forward option, with those additional commodities constituting a hedge.
One of the easiest ways to understand how a forward hedge works is to consider an investor offering a futures option to buy 25,000 bushels of soybeans, with the purchase and delivery date expected to be three months in the future. The seller agrees to the terms, essentially entering into a covenant to deliver all 25,000 bushels on the agreed date, subject to receipt of payment by the buyer. If the seller discovers that he has only 20,000 bushels to meet the terms of the sale, an additional 5,000 bushels will need to be purchased for immediate delivery in order to settle the transaction. That 5,000 bushel would be referred to as the front cover.
The front cover concept also has some impact on the buyer. Just as the seller agrees to deliver the agreed quantity on the specified date, the buyer agrees to provide full payment on that date. This means that even if the buyer doesn’t have the cash on hand to honor the deal, they will have to liquidate the assets or borrow funds to complete the transaction, with those borrowed funds forming a hedge.
In the best of situations, upfront coverage is not necessary. The seller has enough of the goods on hand 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 external source. When the buyer is able to use the futures agreement to buy the assets at a price below the current market value on the delivery date, he can immediately sell the assets and earn a profit on the deal. At the same time, the seller doesn’t have to worry about finding buyers and presumably secured a price on the futures deal that was sufficient to cover all expenses and make some sort of profit.
There are risks associated with upfront coverage. Sellers can end up losing money on the deal if additional units need to be purchased at prices much higher than the unit price agreed upon in the futures sale. Buyers can also find themselves losing money if the goods are currently selling on the market for less than the agreed purchase price. For this reason, both the buyer and the seller should take the time to project the price movement in the market between the date the deal was entered into and the settlement date for the futures agreement, making it easier to managing a term cover, if necessary .
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