Understanding Forward Contracts: Hedging, Speculation, and Counterparty Risk

These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move. They are usually closed out prior to maturity, and 'delivery' usually never happens. In this case, a cash settlement usually takes place.

Because forward contracts are private agreements, there is a high counterparty risk. This means there may be a chance that one party will 'default'.

Traditionally, participants in the futures market have been classified as either hedgers or 'speculators'.

Hedgers are parties at risk with a commodity or an asset, which means they are 'exposed' to price changes.

By taking a position opposite to that of one already held, at a price set today, hedgers plan to reduce the risk of 'adverse' price fluctuations - that is, to hedge the risk of unexpected price changes.

Customers who desire to buy or sell futures contracts open accounts at 'brokerage' firms that execute futures transactions.