Introduction to Financial Derivatives - Forward Contracts

To quickly reiterate, there are the following four basic derivatives:

- Forward contracts
- Futures contracts
- Swap contracts
- Option contracts

In this post we will look at forward contracts.

Forward Contracts
A forward contract is an agreement to buy something at a specified price on a specified future date.

A simple example:
You are planning a trip abroad in a months time. You will need to get some foreign currency for your trip. Let's say that you are going to the States, so you will need to get some US Dollars with you. The current exchange rate is 1.56, which means that for £1 you can get $1.56. For some strange reason you feel that the US Dollar will get stronger and by the end of that month your British pound will get less than $1.56 (let's say $1.52). So, you decide to "lock" the price and order US Dollars now to be delivered to you in a months time (just before your trip) with an exchange rate of 1.56. Automatically you are entering into a forward contract whereby you agree to buy something (US Dollars) at a specified price ($1.56 for £1) on a specified future date (in a months time).