Forward purchase contracts, also known as forward contracts or forward agreements, are a useful tool for investors and businesses alike. In this article, we will explore forward purchase contracts in detail and understand how they work.
What is a forward purchase contract?
A forward purchase contract is a binding agreement between two parties, where the buyer agrees to purchase a specific commodity or asset at a predetermined price, on a future date. The price and delivery date are agreed upon at the time the contract is signed. Forward purchase contracts are common in the commodities market, where the price of goods is volatile and subject to fluctuations.
How do forward purchase contracts work?
Let`s take an example of a farmer who grows wheat. The farmer is worried that the price of wheat may decline by the time the crop is ready for harvest. To mitigate this risk, the farmer enters into a forward purchase contract with a buyer. The buyer agrees to purchase the farmer`s entire wheat crop at a predetermined price, say $10 per bushel. The contract is signed at the beginning of the crop season.
At the time of harvest, the price of wheat has dropped to $8 per bushel. However, since the farmer has a forward purchase contract, they are still guaranteed a price of $10 per bushel. The buyer, on the other hand, benefits from the contract, as they are paying a lower price than the current market rate.
Forward purchase contracts are usually settled in cash. The buyer pays the agreed-upon price to the seller, irrespective of the current market value of the asset.
Types of forward purchase contracts
There are two types of forward purchase contracts:
1. Financial forward purchase contracts: These are contracts that involve financial assets, such as stocks, currencies, or bonds. In this case, the buyer agrees to purchase a specified number of shares of a particular stock or amount of currency on a future date at a predetermined price.
2. Physical forward purchase contracts: These are contracts involving physical assets, such as commodities and real estate. In this case, the seller agrees to sell a particular commodity or property to the buyer at a predetermined price on a future date.
Benefits of forward purchase contracts
Forward purchase contracts offer various benefits to both buyers and sellers.
1. Risk mitigation: Forward purchase contracts help reduce the risk of market volatility. Both parties can agree on a price in advance, which protects them from adverse market fluctuations.
2. Price certainty: Forward purchase contracts provide price certainty to both buyers and sellers. They know the price they will receive/purchase the asset irrespective of the current market value.
3. Improved planning: Forward purchase contracts enable businesses to plan their operations better. With a guaranteed selling price, farmers can plan their crop yields better.
Conclusion
Forward purchase contracts are an essential tool for businesses and investors alike to manage risk and ensure price certainty. By agreeing on a price in advance, both parties can mitigate the risk of market volatility and plan their operations better. Whether it`s a physical asset or a financial asset, forward purchase contracts are a useful tool that helps businesses navigate the uncertainties of the market.