What Is A Forward Contract, And How Is It Used In Hedging

Key Takeaways

1. If you sign a forward contract, you lock a future price today. This gives you certainty of receiving a definite amount and can plan further. 
    
2. They are private contracts and fully customisable. That means you get flexibility but there are risks as well.
    
3. Forwards are widely used to hedge currency and interest-rate. However, you can lose the profit if any of the conditions changes in your favour. 

A forward contract is a deal between two people to buy or sell something at a fixed price on a set future date. It helps protect them from price changes in things like gold, dollars, or company shares.

Let’s understand it better with an example. Priya is an Indian exporter who expects to receive $50,000 in 3 months. Today’s exchange rate is ₹87.72/$. If the rupee strengthens to ₹80/$, she would lose ₹3,86,000.

So, she signed a forward contract to fix the rate at ₹87.72/$. She eliminated uncertainty and had the freedom to plan accordingly. 

The table below summarises Priya’s situation and finances.
 

She was smart to sign a forward contract because ‘Donald aur Dollar kisi ka koi bharosa nahi!’ She not only saved herself from the loss of ₹3,86,000, but also from the anxiety of ‘kitne paise ayenge? Manufacturers ko bhi to dene hai, kaise denge?’ 

Markets can be unpredictable, but your finances shouldn’t be. A forward contract offers clarity, stability, and anxiety-free transactions. So, just like Priya, let’s know more about the special contract and how it will give us an edge to hedge.

What Exactly Is a Forward Contract?

Let’s summarise what we know so far: a forward contract is:

• A private agreement between two parties
   
• One agrees to buy, the other to sell an asset
   
• At a fixed price, on a future date

Unlike stock market contracts, forward contracts aren’t traded on an exchange. They are made directly between buyer and seller, and are customised to their needs. This makes them useful for businesses, exporters, farmers, or anyone wanting safety and avoiding uncertainty.

Read More – Top 10 High-Risk Investments with Huge Returns in 2025 – Should You Try Them

Main Features of a Forward Contract

Let’s keep it simple. A forward contract has some unique traits that are discussed in the table given below:
 

Forward contracts are simple once you break them down. They offer flexibility and privacy, but need trust between both parties to work well.

Do you know  among Indian firms which are employing derivatives for risk management, 84% rely on forward contracts for hedging purposes? qtanalytics.in.

How Forward Contracts Are Used for Hedging

‘Duniya 2012 mein khatam hone wala tha!’

We don’t know about ‘duniya’, but your profits may get reduced if you don’t have a forward contract. Why? Aren’t you seeing unpredictable currency or interest rate fluctuations near you, darling? 

A forward contract is your prince in shining armour. Let’s see how these are used in hedging:

1. Currency Risk Hedging

Businesses such as exporters and importers lock in a fixed exchange rate today because, as said earlier, ‘Donald aur Dollar ka koi bharosa nahi!’

For example, between November and January, Indian firms increased long-term forward dollar hedges (for maturities over one year) by 25% compared to the prior quarter. This helped them protect against the rupee’s depreciation from ₹84 to ₹88/USD and a reduction in their payments. 

2. Interest Rate Hedging (Using Forward Rate Agreements: FRAs)

Large institutions use FRAs to lock in future interest rates on loans or bonds. They do so to ensure a stabilising income and less risk exposure to interest rate changes.

For example, in mid‑2025, LIC entered into $1 billion worth of FRAs with JPMorgan and Bank of America. This accounted for 38% of all FRA volume in India since May, and it has successfully locked in bond yields amid market uncertainty. 

3. Hedging Strategy Adjusted by Policy Shifts

Changes in central bank policies can influence the attractiveness of hedging strategies. The shift can lead companies to adjust their hedge ratios significantly.

For example, after the RBI reduced its currency interventions, daily rupee volatility nearly tripled. As a result, companies like Hari Krishna Exports raised their hedge ratios from 60-70% to up to 90% of their forex exposures. Forward hedges via forward contracts became far more appealing. 

What Are the Real Benefits & Limitations of Forward Contracts?

Till now, you might have some ideas of the pros and cons of Forward Contracts. So, let’s summarise 3 benefits and 3 limitations in the following tables: 

Also Read - What Are Derivatives In The Stock Market? Types, Uses & Risks

The table below lists the benefits of using forward contracts. 
 

So if you're looking to lock down future prices and add predictability, forwards are a handy tool to explore.

To know about the limitations of formward contracts, refer to the table given below. 
 

So while forward contracts can protect you from the unknown, they can also tie your hands when conditions change.

Conclusion

Forward contracts offer stability just like ‘pinky promises’. Even in uncertain markets, you can guarantee a fixed payment from the payee. These contracts are extremely useful for budgeting and risk management. However, they come with drawbacks like limited flexibility and no benefit from favourable market changes.

Frequently Asked Questions

Are forward contracts regulated in India?
Forwards in commodities and forex markets are generally over-the-counter (OTC) and regulated by the RBI or SEBI, depending on the asset class.

How is the forward rate determined?
It’s calculated using the spot rate and interest rate differential between the two currencies or assets involved, often using the formula:
Forward Rate = Spot Rate × (1 + Interest Rate of Base Currency) / (1 + Interest Rate of Quote Currency).

How are forward contracts legally documented for large institutions?
Large counterparties typically use an ISDA Master Agreement with confirmations and a Credit Support Annex (CSA) to standardise terms and manage collateral.

Can small businesses access forward contracts, and how?
Yes, SMEs can hedge via their bank’s forward facilities or through specialised brokers/fintech platforms that offer simple forward products tailored to smaller ticket sizes.

How are forwards valued and reported on financial statements?
Forwards are marked-to-market (MTM) for accounting. That means gains/losses and any collateral movements are recognised as per the accounting standards applicable (IND AS/IFRS/GAAP).
 

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