Forward Price

Definition

The Forward Price is referred to as the agreed-upon price of an asset in a forward contract that will be delivered and paid for at a future date. This price is determined by the spot price of the asset, the risk-free rate, storage costs, and dividend payments. It’s important to note that a forward price itself, does not account for counterparty credit risk.

Phonetic

The phonetics of the keyword “Forward Price” is: /ˈfɔːrwərd praɪs/

Key Takeaways

“`html

1. Future Projection: The Forward Price is essentially the predicted or agreed price of a certain asset at a specified future date. It is used as a future benchmark and its main purpose is to hedge against the risk of price fluctuation.
2. Determination of Price: The forward price of an asset is determined by factors including the current spot price, the risk-free rate of return, the time to maturity, and any carry costs such as storage or dividends. The formula for calculating forward price is: Forward Price = Spot Price * e^(r*t), where e is the base of natural logarithm, r is the risk-free rate, and t is the time to maturity.
3. Risk Aspects: While the Forward Price is a useful tool to mitigate risk, it also comes with its own set of risks. For instance, if the predicted forward price greatly differs from the market price at the contract’s maturity, a party could end up losing money. It is also subject to counterparty risk, where one party may fail to fulfill their contractual obligations.

“`

Importance

The forward price is a significant term in business and finance as it represents the agreed-upon price of an asset in a forward contract, which is designed to be paid and delivered upon at a future date. The importance of this concept lies in its role in mitigating future financial risk associated with price fluctuations. Businesses use forward contracts as a form of hedging to stabilize revenues or costs of their operations. The forward price thus aids in ensuring certainty in volatile markets, specifically for commodities, securities, or foreign exchange. Consequently, it helps in strategic decision-making, financial planning, and risk management.

Explanation

Forward Price plays a critical role in the financial world, particularly in regard to futures contracts and forward contracts. These are instruments which act as agreements to purchase or sell an asset at a specified price on a predetermined future date. The ‘Forward Price’ in this context serves the purpose of identifying that specified predetermined price – or, in other words, the price to which both parties mutually agree upon at the time of entering the contract.The utilization of Forward Price can be seen in multiple segments of the business world. It is often employed for hedging purposes within commodity markets, where producers and consumers use it to shield themselves from price volatility. For instance, a farmer (producer) and a bread manufacturer (consumer) might decide to enter a futures contract at a certain Forward Price to avoid potential loss that could arise from unpredictable changes in the market price of wheat. Equally, it holds importance within investment strategies, allowing investors to lock in prices for assets now, effectively taking a view on where they believe the market price will be at the contract’s maturity date.

Examples

1. Commodity Contracts: The most common example is in the commodities industry. A farmer may agree on a forward price contract with a buyer for his grain harvest six months in advance. This agreement means the buyer and farmer are locked into this transaction at predetermined prices, regardless of changes in market prices. It secures the farmer’s income and allows the buyer to manage cost risk.2. Foreign Exchange Markets: Forward prices are also used in the foreign exchange markets where multinational corporations often look to hedge their foreign currency exposure. For example, a US-based company expecting a payment in Euros six months from now may enter into a forward contract to sell Euros at a future date at a predetermined forward price. No matter how exchange rates fluctify, the company knows exactly how much they will get in USD from that future payment.3. Securities: Another context where forward prices are frequently applied is in the area of security trading. An investor could agree to forward contracts for the purchase of shares in a particular company. For instance, an investor can enter into a contract agreeing to buy 100 shares of Company X at a forward price of $50 per share three months from now. This would be advantageous if the investor expects the share price to rise in the future. Regardless of whether the shares are trading at $55 or $60 three months later, the investor will be able to buy them at the agreed forward price of $50.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Spot Price
• Derivative Contract
• Hedging
• Future Contract
• Market Risk

Sources for More Information

• Investopedia
• Corporate Finance Institute
• The Balance
• Fidelity