A forward contract sets a specific price range for an underlying asset, with parties undertaking to buy or sell a fixed quantity at a specified price on a future expiration date. A fixed-term contract establishes a price range for the underlying asset and an expiration date, with the trade never going below or beyond the range. The holder of a fixed-term contract often uses it to hedge or protect a position in the underlying asset. There are often no upfront costs to enter into a forward contract.
A forward contract sets a specific price for an underlying asset, which could be a commodity, an exchange rate, or another financial instrument. When two parties enter into a forward contract, they undertake the obligation to buy or sell a fixed quantity of the underlying asset from the other party at a specified price on a specified future expiration date. Instead of a specific price, the forward contract locks in a price range for the underlying asset. This allows the holder to benefit from small price movements while protecting himself from larger movements.
A fixed-term contract establishes a price range for the underlying asset and an expiration date. If the price of the underlying asset at expiration is below the range, the parties to the contract will trade at the lowest rate within the range. If the price of the underlying asset at expiration is within the range, the transaction will be at the market rate. If the price of the underlying asset at expiration is above the range, the transaction will carry the higher rate within the range. The trade will never go below or beyond the range.
For example, a US company expects to buy British Pounds (GBP) in three months and the US dollar (USD) / GBP rate is currently 1.6273. The company can enter into a forward contract with a band of 1.6000 to 1.6400. At the end of the three months, on the expiration date, if the USD/GBP rate is below 1.6000, the company will buy the coin at $1.6000 USD/GBP. If the USD/GBP exchange rate is between 1.6000 and 1.6400, the company will buy it at the prevailing exchange rate. If the USD/GBP rate is greater than 1.6400, the company will pay $1.6400 USD/GBP for it.
The holder of a fixed-term contract often uses it to hedge or protect a position in the underlying asset. For example, a company expects to earn income or make a payment in a foreign currency and wants to ensure that it does not suffer losses due to exchange rate fluctuations. A farmer who produces a product can also sign an advance range contract to guarantee a minimum price for his next crop.
There are often no upfront costs to enter into a forward contract. Being a contract between two parties, the parties can adapt the terms to their preferences. The disadvantage of a fixed term contract is that the floor rate, which is the lowest rate within the specified range, is generally lower than the rate of a simple forward contract. The holder is also unable to take full advantage of a favorable price movement due to the existence of the rate cap.
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