Forward Market Meaning
Forward Market refers to a market which deals in over the counter derivative instruments and thereby agree to take delivery on a set price and time in the future. In addition, the contract can be customized with regard to the rate, quantity and also with regard to the date.
Classification of Forward Market
- Closed Outright Forward: Under this type of contract, the exchange rate is fixed between the two parties upon an agreement as per the prevailing spot rate plus the premium.
- Flexible Forward: Under this method, the parties can tend to exchange funds which are usually on or even before the maturity date.
- Long Dated Forward: They are similar to the short-dated contracts except that the maturities are usually for distant dates
- Non-Deliverable Forward: Under this method, there is no physical delivery except that the parties agree to settle only the difference between the spot rate and the exchange rate
Example
Let us consider the example of a farmer who harvests a certain crop and is unsure of its price three months down the line. In this case, the farmer can enter into a forward contract with a certain third party by locking in the price at which he would sell his crop in the upcoming three months. The market for such a transaction is known as the forward market.
Features
- In this market, trading is done by telephone, where participants directly deal with the broker-dealers.
- The private parties themselves negotiate the contract terms and are dealt on a principal to principal basis.
- Most transactions are delivery based.
- Usually, the products are OTC based and are customizable with regard to quantity, delivery dates, and price.
- It is generally not regulated by anybody.
Importance
- It helps the parties to the contract to fix the future price at which a particular underlying will be exchanged.
- It helps the individual or corporation to hedge against uncertainties in the future.
- It helps individuals who look for customization in their contract and do not want to directly deal in the futures market where there is standardization for each contract or the underlying product.
- It also helps certain corporations to hedge their FX exposure when there are payments to be received/paid in the future.
Forward Market vs. Futures Market
- Forward markets usually deal with OTC products, whereas futures markets deal with products on exchanges.
- Forward markets have the terms negotiable among the parties with regard to the contract size, date of delivery, whereas futures contracts are more standardized.
- Forward markets usually have physical delivery, whereas a futures contract is cash-settled.
Benefits
- Offers complete hedge: Whenever a certain seller has certain commodities to exchange in the future for which the price is uncertain, or there happens to be an exporter who wishes to lock in the exchange rate at which the payment must be received, he may do so in the forward market by entering into such contracts. Such contracts, therefore, happen to provide complete hedge and try the maximum to go on to avoid such uncertainties so that parties are assured of the payment rates.
- Customization: At times, one party may not be willing to enter into such contracts through futures as the terms and conditions of the contract are well stated and standardized, and it is only forward markets that provide such flexibility to customize the forward contracts. The parties at their own will may decide on the quantity, time, and also the rate at the time of delivery as per their needs and specifications. This adds a lot of convenience to both the parties owing to the flexibility options that this market provides. They happen to be tailor-made for the parties and can thus be adjusted for any duration and amount.
- Matching of exposure: Owing to the feature of flexibility and customization, the parties can now match their exposure with the time-frame of the period during which they decide to enter into the contract. If the horizon happens to be for a period of 2 months rather than the standard of 3 months in the futures contract, the parties can enter into such contracts as per their will so that their exposure is hedged in accordance with their time-frame. Owing to the contracts being tailor-made to suit the parties, they can be customized to suit any party and thus modify the duration.
- Over-the-counter products: The products generally tend to be dealt over the counter, and thus owing to the flexibility that they provide, huge institutional investors such as hedge funds tend to prefer to deal with them rather than entering into a standardized futures contract. Over the counter, products give them the advantage of the flexibility to suit their strategy, duration and contract size as per their needs and requirements.
Limitations
- Difficulty in cancellation: At times, the contract, once entered into may not be canceled, and sometimes the parties often do default as they are not so regulated, unlike the futures contract
- Difficulty in finding a counterparty: Since they are OTC products at certain times, there may be difficulty in finding a similar counterparty to contract with for the forward contract
Conclusion
Forwards being a significant financial instrument act as a derivative so that the underlying exposure is fully hedged, stands as an outstanding tool to achieve the required protection. Thanks to their feature of customization to suit the needs and requirements of the counterparties to the contract, they happen to be a preferred favorite to deal with in the forward market as they can very well be tailor-made to suit the requirements of the parties.
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