A forward contract is a contract between two parties to lock a rate for a transaction to occur on a specific future date. Forward contracts can be used by individuals to hedge the risk of unfavorable fluctuations in the prices in the future.
For example, a United States exporter is expecting to receive Euros 500,000 in the next three months. The current exchange rate is 1 Euro = 1.5 USD. The exporter thinks that the USD will strengthen in the next three months against Euros and he will receive less USD in exchange for Euros. To hedge this risk the exporter enters an exchange rate forward contract that offers to sell Euros 500,000 at 1 Euro = 1.45 USD.
Assume after three months the USD strengthened to an exchange rate of 1 Euro = 1.2 USD. As per forward rate contract the exported will still receive USD 725,000 (Euro 500,000 x 1.45) whereas he would have received USD 600,000 (Euro 500,000 x 1.2).
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