an agreement or a promise to take action at a future date. In the business and finance world, an advance commitment refers to the buying or selling of an asset on a future date and under pre-determined terms.
Advance Commitment Details
Advance commitments are agreements made ahead of the sale or service date. These commitments come with clear terms that both parties agree upon on the day they commit. If the sale of an asset is included in this type of contract, the selling party member determines the product's price on the same day they set terms for the contract. The seller and buyer can decide that they will determine the sale price according to market prices on the action date. But once they reach an agreement on a price, that is what they must follow.
In some cases, the seller or buyer may find that the advance commitment agreement will not be suitable as they had initially agreed to it. To remove the advance commitment obligations before the agreement's expiry date, they would have to take an offsetting position. By doing so, the seller can avoid the risk of financial loss, and they will have the chance to adjust the price of the asset.
Advance commitments can lead to loss depending on how the market fluctuates between the time of the agreement and the actual sale date. For example, the seller may commit to purchasing a good at an agreed price. However, the market price may be lower than what they committed to pay at a later date. They will still be bound to pay up the amount agreed upon to the seller. Should the market price go higher at a later date, the seller would have missed out on making some extra profits.
Advance Commitment Example
People make advance commitments in various aspects of life, in business and in the financial markets. The parties that relate in such a manner usually have developed a sense of trust and credibility. They play an important role by ensuring smooth transactions take place.
An example of advance commitment in the stock market is short selling. Short selling is a situation whereby an investor sells stock that they are yet to own. The investor has the intention of buying it back at a future date at a lower price. In such cases, it is unknown when the trader will buy the shares and at which price.
Mortgage banking is another example of an advance commitment. In an agreement between a borrower and the bank, the lender makes an advance commitment to lend funds to the borrower at a future specified date and upon agreed terms. This is also known as a standby commitment. With a mortgage, the home buyer can complete the agreement since they know the bank has committed to funding the purchase. In this type of advance commitment, the date the bank grants the loan and the date on which the bank sends the funds to the home seller are usually different.