Forward Contract

Forwards and futures contracts are a special type of derivative contract. Forward contracts were initially developed in agricultural markets. For example an orange grower faces considerable price risk because they do not know at what price their crops will sell. This may be a consequence of weather conditions (frost) that will a ect aggregate supply. The farmer can insure or hedge against this price risk by selling the crop forward on the forward orange concentrate market. This obligates the grower to deliver a speci c quantity of orange concentrate at a speci c date for a speci ed price. The delivery and the payment occur only at the forward date and no money changes hands initially. Farmers can, in this way, eliminate the price risk and be sure of the price they will get for their crop. An investor might also engage in such a forward contract. For an example an investor might sell orange concentrate forward for delivery in March at 120. If the price turns out to be 100, the investor buys at 100 and delivers at 120 making a pro t of 20. If the weather was bad and the price in March is 150, the investor must buy at 150 to ful ll her obligation to supply at 120, making a loss of 30 on each unit sold. The farmer is said to be a hedger as selling the orange concentrate forward reduces the farmer's risk. The investor on the other hand is taking a position in anticipation of his beliefs about the weather and is said to be a speculator. This terminology is standard but can be misleading. The farmer who does not hedge their price risk is really taking a speculative position and it is di cult to make a hard and fast distinction between the two types of traders.