In the context of finance, what do forward contracts typically involve?

Forward contracts are agreements between two parties to buy or sell an asset at a predetermined price at a future date. The crucial aspect of a forward contract is that the price is fixed at the time of the contract's initiation, allowing both parties to have certainty about what the price will be at the time of the transaction in the future. This feature is beneficial for hedging purposes, as it helps mitigate the risk associated with price fluctuations.

The nature of forward contracts distinguishes them from other financial instruments. For example, cash settlements or negotiations based on current market prices do not apply here, since the main purpose of a forward contract is to lock in a specific price today for a future transaction. Additionally, forward contracts do not involve direct investments in stocks or other securities; rather, they are typically used for commodities, currencies, or other financial instruments where future delivery and pricing are relevant.

In this context, understanding that the price is predetermined and the transaction occurs in the future is key to grasping how forward contracts function within the broader framework of risk management in finance.