How does a forward contract work as a hedging device?
A forward contract locks in an interest rate or exchange rate for a specified future time. It insulates the company from changes to that rate until the exercise date of the contract. Consider, for example, a company with an account receivable of 10,000 Swiss francs due to be collected in 90 days. The company will have to convert the francs to dollars at that time, but the exchange rate 90 days from now is unknown hence the company faces foreign exchange risk. By purchasing a forward exchange contract, the company can guarantee the rate of exchange and eliminate the risk. The forward contract, a liability to deliver 10,000 francs in 90 days hedges the account receivable asset, the right to receive 10,000 francs in 90 days by providing a way for the company to use the proceeds from the asset and receive a known value.fi