Association for Financial Professionals (AFP) Practice Exam

Which factor is often considered a disadvantage of forward contracts?

1. They can be customized

2. They do not involve daily market adjustment

3. They can be for any amount

4. They can cover any time period

The correct answer is: They do not involve daily market adjustment

Forward contracts are agreements to buy or sell an asset at a specified future date for a price that has been agreed upon today. While they offer flexibility in terms of customization, amount, and duration, one significant disadvantage is that they do not involve daily market adjustments. This means that the price is fixed at the time the contract is initiated and remains unchanged until the contract's maturity. The absence of daily market adjustment creates exposure to market risk. If market conditions change and the price of the underlying asset moves unfavorably, the parties involved in the forward contract are stuck with the original terms. For instance, if the market price moves significantly in one direction after the contract is signed, the party obligated to fulfill the contract may end up paying much more than the current market rate upon contract settlement. This contrasts with instruments like futures contracts, which do adjust daily, effectively mitigating credit risk and market exposure over time. Overall, the fact that forward contracts lock in a price without the benefit of market adjustments until maturity can be a disadvantage, particularly in volatile markets, where pricing can change significantly before the contract execution date. This aspect underscores the inherent risk associated with these contracts, particularly for entities looking to manage cash flow and budget with a degree of certainty in fluctuating