A forward contract involves a contract agreement between two parties where there is an agreement to buy or sell an asset at a set price on a specified date in the future (Pettinger, 2019). The main purpose of a forward contract is to prevent future losses as it enables the buyer and seller to hold on to an agreed price in the future. In this case, purchasing the car on a forward contract provides an arbitrage opportunity. Such is because arbitrage provides a risk-free profit. An investor can purchase at zero initial cost with no risk of future loss and non-zero profitability of future profit. Therefore, in purchasing the car through forward contract, my initial cost would be zero, and there would be no risk of future loss as the purchasing price had already been agreed. Therefore, the forward contract provides a good arbitrage opportunity.
However, buying the car through purchasing a currency would involve many risks as the currency market is very volatile. This would lead to a huge potential loss if the currency I bought depreciated before the three months' expiry. For instance, if we had an agreed price of $ 1000, which was trading at $1.5 against one Australian dollar, it means I would buy the car at 1500 Australian dollars. However, if the Australian dollar depreciates and the Us dollar trades higher at $1.8 against one Australian dollar, I would be required to pay 1800 Australian dollars at the end of the three months. Such would come with a potential loss of 300 Australian dollars compared to a no loss if the forward contract were used. Therefore, making it the best alternative in purchasing the car.
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Forward contracting is beneficial as it prevents losses due to unprecedented downside risk exposure as prices are fixed, thereby providing certainty in the exchange rate (Pettinger,2019). Moreover, it provides flexibility in the amount being paid by the buyer.
References
Pettinger, T. (2020, February 29). Effect of the exchange rate on business . Economics Help. https://www.economicshelp.org/blog/9328/business/effect-exchange-rate-business/
