what is ‘Forward Market Hedging’?

Forward market hedging is a way of reducing the volatility in
future profits by creating contracts in advance to buy or sell goods in the
future.

Producers can predict with a fair amount of accuracy what
their production in the future might be and the amount of raw material that they would require.
An increase in the cost of raw material could adversely impact their revenues, so can a decrease
in the selling price of what has been produced.

One of the ways of
hedging this risk is with forward contracts. These are over-the-counter contracts created between
a seller and a buyer to sell or buy a certain quantity of an asset at a certain price in the
future. This eliminates the risk that may arise due to a change in price and also provide an
assurance that a buyer or a seller will be available in the
future.

For example, a farmer who grows wheat and a biscuit
manufacturer can create a contract which specifies that in June the farmer will deliver 100 tons
of wheat with a minimum 25% starch content to the manufacturer at $1 per kilogram. The contract
could also include details like where the delivery has to be made, how the wheat has to be
processed, who checks the quality, etc. By entering into such a contract, the farmer is assured
of receiving $100,000 for the wheat that is grown by him irrespective of what the actual price of
wheat in June is. The biscuit manufacturer is also assured of getting the wheat which is a
primary component in making biscuits at the price that is mentioned in the
contract.

Forward contracts are not traded in exchanges and are
custom made. As there is no clearing house involved here, the chances of default are higher. This
makes it essential to evaluate the ability of the opposite party to honor the contract and to
introduce clauses in the contract to reduce the risk of default for both the
parties.