Forward Market
Refers to the market for forward contract transactions, where the transaction is according to the agreed terms in a future date delivery settlement
What is a Forward Market?
A forward market is a space where people engage in transactions involving forward contracts. In simple terms, a forward contract is an agreement between two parties to buy or sell an asset at an agreed-upon price on a future date.
The forward market is often specifically associated with forward foreign exchange transactions. These transactions involve the exchange of currencies at a predetermined rate on a future date. Unlike standardized futures contracts traded on exchanges, forward contracts are customized agreements between two parties.
Since forward markets are not regulated by exchanges or clearing houses, there is a risk of delivery issues that you wouldn't find in regulated transactions.
Forward contracts serve as financial instruments for future delivery or to fix the price of an asset. This market operates over-the-counter (OTC), meaning it doesn't occur on a centralized exchange. The term "forward market" is used broadly across various financial sectors, including securities, interest rates, commodities, and foreign exchange.
Key Takeaways
- Forward market involves agreements for future asset transactions, operating without centralized regulation and susceptible to potential delivery risks.
- Forward contracts are part of the over-the-counter market, used for future delivery or price setting in various sectors.
- Forward contracts include Forward Rate Agreements, Forward Foreign Exchange Agreements, and Forward Stock Contracts, each serving specific financial purposes.
- Participants in the forward foreign exchange market include hedgers, arbitrageurs, and speculators, each motivated by different financial goals.
How a forward market works
First, even if a company holds both buy and sell contracts, it is not always possible to guarantee a perfect position closing. For example, if the notice period has expired and the buyer is unable to resell the goods to a third party, the forward market buyer is not only holding a batch of unwanted goods but is also simultaneously obligated to sell another batch of goods to a third party at an appropriate date.
In the 21-day Brent market, the seller must provide the buyer with at least 15 business days' notice. This notice informs the buyer of the exact time on day 1 of the three loading dates, and the transaction concludes at 5 p.m. London time on the 16th business day.
Notices received at or shortly before 5:00 p.m. on the 16th business day will not be passed on, and some savvy traders in the forward market tend to cut off telephone or telex contact at nearly 5:00 p.m. to avoid the "5:00 p.m. notice".
Secondly, forward contracts default to plus or minus 5% to 10% of the short premiums loaded, often at the seller's discretion. Although this is intended to increase the flexibility of the transaction, it is often used by the seller as a means of maximizing profits or minimizing losses, so it is impossible for the buyer to know exactly the actual, accurate delivery quantity.
In the European open-spec naphtha market, such premium short-lot quantities can typically reach 17,000 to 25,000 tons, averaging at 8,000 tons, or about 40% of the average delivery quantity.
Finally, in the forward contract market, where delivery is made at CIF prices, if the buyer delays giving notice until the next delivery month, there will be delays in unloading and ship demurrage, which will be passed down the chain of transactions in the forward contract market.
This exposes the buyer to the risk of bearing the potential costs, and some traders will seek legal redress from the companies that should indeed pay these costs.
In response to this, the European open specification naphtha market specifically provides that all traders in the forward market trading chain share in the demurrage costs of the vessel rather than the final trader alone.
Forward contract
It is an agreement between two parties of a transaction to buy or sell an asset at a determined time in the future for a determined price, where the contracting parties have both the right and the obligation to perform the agreement.
In a contract, the party that will buy the underlying in the future is called being in a long position, while the party that will sell the underlying in the future is called being in a short position.
A forward contract does not guarantee its investor a sure future profit, but the investor can obtain a definite future purchase or sale price through the forward contract, thus eliminating price risk.
If the market price of the underlying asset at maturity is higher than the delivery price, the forward longs will profit and the shorts a loss; conversely, the forward longs will make a loss and the shorts a profit.
Depending on the underlying asset, the following three types of financial forward contracts are common:
1. Forward Rate Agreement
A remote rate agreement is an agreement between a buyer and seller to borrow a notional principal amount at an agreed interest rate for a specified period, starting at an agreed future point and expressed in a specified currency.
The most important element of the contract is the agreed interest rate, which we usually call the forward rate, i.e., the interest rate for a certain future period at the present moment.
2. Forward Foreign Exchange Agreements
Forward foreign exchange contract refers to the two sides agreeing to buy and sell a certain amount of foreign exchange contract in the future at a particular time according to the agreed exchange rate.
In accordance with the beginning of the forward period, forward foreign exchange contracts are divided into direct forward foreign exchange contracts and forward foreign exchange comprehensive agreements.
It should be noted that in some countries, due to foreign exchange control, the principal may not be delivered.
This kind of foreign exchange forward contract is called principal non-deliverable forward (NDF), which is different from the main deliverable but non-deliverable forward.
3. Forward Stock Contracts
A forward stock contract is an agreement to deliver a certain number of individual stocks or a basket of stocks at a specific price on a specific date in the future.
Forward stock contracts have been around in the world for a short time, and the total size of transactions is not large.
Futures Contract
Trading mechanisms in the forward market include decentralized over-the-counter trading and non-standardized contracts.
The advantage is that there is a lot of flexibility, forward contracts can be entered into according to the specific needs of the two parties to the transaction, and it is easier to circumvent regulation.
Similarly, the disadvantages of the forward market are obvious, mainly the following three points:
- There is no fixed centralized trading venue, which is not conducive to the exchange and transmission of information, the formation and discovery of uniform market prices, and low market efficiency;
- Each forward contract is very different, and the liquidity is poor;
- There is no guarantee of performance, and the risk of default is relatively high.
An essential difference between futures and forwards lies in the difference in trading mechanisms. In contrast to non-standardized forward contracts that are traded over the counter, futures are standardized contracts that are traded on an exchange.
Exchanges also provide for special trading and delivery systems, such as Mark to Market and Daily Settlement and Margin (a debt-free operating mechanism that almost fundamentally ensures that futures are not subject to default).
forwards Vs. futures
The main differences between forwards and futures are as follows:
1. Trading venues are different
Forwards do not have a fixed trading venue, while futures contracts are traded on an exchange and are generally not allowed to be traded over the counter.
2. The degree of standardization is different.
Forward contracts offer a great deal of flexibility, but they also create many problems for the transfer and circulation of contracts. Futures contracts, on the other hand, are standardized.
Standardized terms make it difficult for futures to meet specific trading needs, but they also make futures contracts extremely liquid.
3. The risk of default is different.
In the event of non-performance by one party, the other party suffers a loss. Both parties to a futures contract transaction are directly exposed to the exchange, and even if one party defaults, the other party is hardly affected.
4. Relationship between the contracting parties
Unlike forward contracts, which are entered directly between the two parties to the transaction, the risk of default on a forward contract depends primarily on the counterparty's creditworthiness.
The performance of a futures contract does not depend at all on the counterparty but only on the exchange or clearing agency.
5. The price is determined in different ways.
The delivery price of a forward contract is negotiated directly and privately by the two parties. For futures trading, the price is determined through public bidding or trading based on market maker quotes.
6. The settlement method is different.
After the forward contract is signed, only the settlement is cleared at maturity, and no settlement is made in the meantime. Futures transactions, on the other hand, are settled daily.
7. Different settlement methods
Since forward contracts are non-standardized, it is not easy to find a transferee, and the original counterparty's consent must be obtained, so most forward agreements can only be closed by physical delivery or cash settlement at maturity.
Forward foreign exchange market
Forward foreign exchange market refers to the transaction day trading parties to the agreed foreign exchange currency, the amount, and the exchange rate, in the agreed future date settlement of a foreign exchange to the currency of the transaction market.
The main function of the forward foreign exchange market is to avoid the risk caused by the fluctuation of the spot exchange rate. The general forward foreign exchange market participants can be divided into three categories:
1. Evacuees
For example, a Taiwanese exporter can receive a payment in U.S. dollars from a U.S. customer three months later.
To avoid a significant depreciation of the U.S. dollar when the amount is converted to NTD three months later.
The exporter can first sell a considerable amount of March forward foreign exchange in the forward foreign exchange market. Then he will be sure that the exchange rate agreed upon at the beginning can be converted to NTD to avoid the exchange risk.
2. Arbitrageurs
According to the interest rate gap between countries, under the assumption of a perfect market, capital will flow from low-interest rate countries to high-interest rate countries.
In this case, capital will flow internationally, affecting the exchange rate changes and may produce a temporary derailment phenomenon between spot and forward exchange rates. Arbitrageurs can use this to engage in arbitrage behavior to earn profits.
3. Speculators
This kind of participant's motive is if its future trend of the exchange rate forecast has a unique judgment and is willing to bear the exchange rate changes brought about by the risk.
The pursuit of their expectations correctly brought about by the profit, also because of the above participants to join the market, and promote the forward foreign exchange market booming development.
Forward Market FAQs
The spot market is a type of trading that facilitates the immediate use of cash for transactions such as spot commodities or other assets. The settlement price of a transaction before the scheduled date is the forward rate, provided that no transaction occurs.
People can reduce risk and fix the price of an asset or financial instrument at a future time by entering into contracts in the forward market. This is one of the main functions of the forward market.
Forward rates have different definitions in different markets. The basic definition is that the settlement price at which no transactions take place is before a predetermined date.
In the bond market, it is the effective yield on a bond, and this rate can be calculated from the interest rate and maturity date.
A venue that offers monetary transactions for spot commodities or other assets is the spot market. This also involves futures trading.
Hedging involves the use of foreign exchange forwards. It refers to the use of forward rates to directly purchase another currency. This action is influenced by the exchange rates and interest rates of the two currencies.
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