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What are the Advantages and Risks of Forward Transactions?
Forward transactions are purchase or sale contracts between two parties that will be executed at a certain price on a certain date. Forward transactions can be made to hedge against future price fluctuations or to generate speculative profits. The advantages and risks of forward transactions are:
Advantages:
- Forward transactions make it easier for the parties to budget and plan by eliminating future price uncertainty.
- Forward transactions enable the parties to make agreements by customizing the asset, amount, maturity and price they want. In this way, forward transactions can be preferred when standard products in the market are not suitable.
- Since forward transactions are not limited by market liquidity or depth, transactions can also be made on assets that are not available in the market or are scarce.
- Since forward transactions do not require any brokerage firm or stock exchange, transaction costs are low.
Risks:
- Since forward transactions are based on mutual trust of the parties, there is a credit risk regarding the execution of the contract. If one party cannot fulfill the contract, the other party may suffer losses.
- Forward transactions may gain or lose value depending on changes in market prices. If one of the parties wants to give up the contract in case the market price changes in its favor, the other party's approval is required. This may create renegotiation costs.
- Since forward transactions are not standard, it can be difficult to find buyers or sellers in the secondary market. This reduces the liquidity of forward transactions and limits the possibility of early settlement.