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A forward cover is type of obligation that allows buyers and sellers to establish an arrangement to purchase assets or goods at a fixed price on a future date, with specifics about both the price and the quantity that will be purchased. As part of the deal, the seller must produce the quantity desired, even if he or she is short that amount when the purchase date arrives. In other words, the seller may have to secure addition units in order to meet the terms of the forward option, with those additional goods constituting a cover.
One of the easiest ways to understand how a forward cover functions is to consider an investor who puts in a futures option to buy 25,000 bushels of soybeans, with the purchase and delivery date set to occur three months in the future. The seller agrees to the terms, essentially making a covenant to deliver all 25,000 bushels on the agreed-upon date, subject to receiving the payment from the buyer. If the seller finds that he or she only has 20,000 bushels to honor the terms of the sale, then it will be necessary to purchase another 5,000 bushels for immediate delivery in order to settle the transaction. That 5,000 bushels would be referred to as the forward cover.
The concept of the forward cover also has some impact on the buyer as well. Just as the seller is committed to delivering the agreed-upon quantity on the specified date, the buyer is committed to providing payment in full on that date. This means that even if the buyer does not have the cash in hand to honor the deal, he or she will need to liquidate assets or borrow funds to complete the transaction, with those borrowed funds constituting a cover.
In the best of situations, there is no need for a forward cover. The seller has enough of the goods on hand to complete the transaction, without the need to secure additional amounts elsewhere. In like manner, the buyer has the financial resources on hand to pay for the order without the necessity of obtaining additional funds from an outside source. When the buyer is able to use the futures arrangement to buy the goods at a price that is below the current market value on the date of delivery, he or she can immediately sell the goods and earn a profit from the deal. At the same time, the seller does not have to be concerned about finding buyers and presumably secured a price on the futures deal that was sufficient to cover all expenses and make some sort of profit.
There are risks associated with a forward cover. Sellers may end up losing money on the deal if it is necessary to buy additional units at prices much higher than the agreed-upon unit price in the futures sale. Buyers may also find themselves losing money if the goods are currently being sold in the marketplace for a price under the agreed-upon purchase price. For this reason, both the buyer and the seller should take the time to project the movement of prices in the marketplace between the date that the deal is struck and the settlement date for the futures arrangement, making it easier to manage a forward cover if necessary.
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