Difference between Hedging and Forward Contract

Hedging is a strategy to lower the risk associated with a financial asset. In contrast, a forward contract is an agreement between two parties to purchase or sell an asset at a predetermined price at a later time. This is the main distinction between hedging and forward contracts. Investors are finding that hedging is more and more important as the financial markets have expanded in size and complexity. The relationship between hedging and forward contracts is that the former is a sort of contract used for hedging, and the latter offers assurance with respect to a future transaction.

In short, both are different in their usage and they have differences. Let us now explore the concepts of each and know the key differences between them.

What is Hedging?

Hedging is a strategy for lowering a financial asset's risk. A risk is an uncertainty about what will happen in the future. A hedged financial asset guarantees what its value will be in the future. It is a method for lowering the risk associated with financial assets. There is always a possibility that future earnings may be unexpected. However, by hedging, they can be assured about the future value and date.

A risk management tactic called hedging is employed to lessen the impact of unfavorable market price fluctuations. This involves taking an opposite position in a comparable security, such as an option or futures contract, to protect against potential loss. Businesses frequently employ hedging to reduce the risks brought on by changes in interest rates, commodity prices, and exchange rates.

What is a Forward Contract?

A forward contract, also known as a futures contract, is an agreement between two parties to purchase an asset at a fixed price at a later date. It is tailored to the particular requirements of the parties concerned. Forward contracts, which let companies fix the exchange rate for upcoming transactions, are frequently employed as a hedge against currency risk.

For example, Company A is a business that plans to buy 600 barrels of oil from Company B in six months. Company A chooses to sign a forward contract to remove uncertainty because oil prices are constantly shifting. Thus, an agreement is signed between the two parties under which B would sell 600 oil barrels at a price of $175 per barrel. It doesn't matter if the price changes over time, the price will be fixed according to the contract.

Key Differences between Hedging and Forward Contracts

Although they are both used to control risk, forward contracts and hedging have quite different applications and structures. Some notable differences are as follows:

• Hedging is one method for managing the risk associated with financial assets. A forward contract is an arrangement between two parties to purchase or sell the underlying asset at a specific point in the future.
• An exchange deal or over-the-counter instrument may be used for hedging. An over-the-counter instrument is the key concept in a forward contract.
• The scope of hedging is greater than that of forward contracts. Compared to hedging, the scope of a forward contract is limited.
• Some common hedging tools are swaps, forwards, futures, and options. Hedging instruments include forward contracts.

Difference Table

Example of Hedging vs. Forward Contract

Let us examine a hypothetical situation in which an international manufacturing company experiences currency risk as a result of its operations. The business can choose to sign into a forward contract to lock in an exchange rate for its upcoming transactions or use currency options to hedge its risk.

The business can hedge against unfavorable currency fluctuations and maintain flexibility to profit from favorable ones by employing currency options. However, a forward contract gives the business the assurance and predictability of fixing the exchange rate for all of its future transactions.

Both forward contracts and hedging are useful instruments for risk management in the legal and financial spheres. Both products are vital in protecting firms from the volatility and unpredictability of the market despite their distinct features and varied functions. To negotiate the complexity of financial risk management and give clients informed counsel, legal practitioners need to have a solid understanding of these principles.

Conclusion

Hedging and forward contracts differ primarily in the extent of their use; hedging encompasses a wider range of strategies, whereas forward contracts are more focused. Both aim to reduce the risk associated with a potential future transaction, which is where they have similarities. Furthermore, there is a sizable market for forward contracts in terms of both volume and value; however, estimating the size of this market is challenging because buyers and sellers are the only parties aware of the intricacies of futures contracts.