Credit Risk Another important thing to remember is that with a forward contract, no money changes hands when the contract is initiated. The contract is simply an agreement to transact in the future, so there is no up-front cost to the contract. However, because a forward contract is a financial obligation, there is credit risk. When the settlement date arrives, the party on the losing end of the contract has a significant incentive to default on the agreement. As we discuss in the next section, a variation on the forward contract exists that greatly diminishes this risk.

Where are forward contracts commonly used to hedge? Because exchange rate fluctuations can have disastrous consequences for firms that have significant import or export operations, forward contracts are routinely used by such firms to hedge exchange rate risk. For example, Jaguar, the U.K. auto manufacturer (and subsidiary of Ford Motor Co.), historically hedged the U.S. dollar–British pound exchange rate for six months into the future.

CONCEPT QUESTIONS

a What is a forward contract? Describe the payoff profiles for the buyer and the seller of a forward contract.

b Explain how a firm can alter its risk profile using forward contracts.