Forward Contracts

A forward contract obligates one party to buy the underlying at a fixed price at a certain time in the future,called maturity from a counerparty who is obligated to sell the underlying at that fixed price.Consider a U.S. exporter who expects to receive $100 million in six months. Suppose that the price of the euro is $1.20 now.If the price of the euro falls by 10 percent over the next six months,the exporter loses$12 million.By selling euros forward, the exporter locks in the current forward rate (if the forward rate is $ 1.18, the exporter receives $118 million at maturity).Financial hedging involves taking a financial position to reduce one's exposure or sensitivity to risk,hedging is perfectwhen all exposure to the risk is eliminated through the financial position.In our example,the financial position is a forward contract,the risk is the euro,the exposure is $100 million in six months,and the exposure to the euro is perfectly hedged with the forward contract.Since no money changes hands when the exporter buys euros forward,the market value of the forward contract must be Zero when initiated since otherwise the exporter would get something for nothing