Forward Markets and Contracts

Correct Answer: Price risk, as forward contracts lock in a fixed price for the underlying asset at a future date

The best answer is that forward contracts most effectively mitigate price risk by locking in a fixed price for the underlying asset at a future date. Forward contracts are agreements between two parties to buy or sell an asset at a specified price on a future date. This locks in the price and protects against price fluctuations. If commodity prices rise, the buyer benefits by paying the lower agreed-upon price. If prices fall, the seller benefits by receiving the higher contracted price. Counterparty risk, while a concern with forwards, is not the primary risk mitigated. Forwards have counterparty risk because they are private agreements between parties that could default. Liquidity risk is higher with forwards compared to futures because they are customized contracts without a centralized exchange. The primary purpose is not to improve liquidity.

Correct Answer: The company has foregone potential profits by locking in the lower price

The correct answer is that the company has foregone potential profits by locking in the lower price. By entering into a forward contract to sell 5,000 units at a fixed price of $100 per unit, the company has secured a guaranteed price for their product. However, at the end of the contract period, the spot price has risen to $120 per unit. If the company had not entered into the forward contract, they could have sold the units at the higher spot price of $120 each, generating an additional revenue of $20 per unit, or $100,000 in total (5,000 units * $20 per unit). The company cannot take advantage of the higher spot price at the end of the contract period because they are obligated to sell the units at the agreed-upon price of $100 per unit as per the forward contract. Therefore, by locking in the lower price, the company has missed out on potential profits that they could have realized if they had sold the units at the higher spot price.

Correct Answer: Forward contracts allow hedgers to lock in a price for a future transaction, reducing exposure to price fluctuations.

The key advantage of forward contracts for hedgers is that they allow locking in a price for a future transaction, reducing exposure to price fluctuations. This is the main purpose of hedging - to mitigate the risk of adverse price movements.

The other answers are incorrect because:
- Forward contracts do not provide flexibility to easily adjust terms based on changing market conditions. The terms are fixed at the outset of the contract.
- The purpose of hedging with forward contracts is not to speculate on price movements for potentially higher profits, but rather to reduce risk exposure. Speculation would increase risk.