Forward Market Meaning Example Forward Vs Futures Market

Forward Market Meaning

Classification of Forward Market

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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 rateSpot RateSpot Rate’ is the cash rate at which an immediate transaction and/or settlement takes place between the buyer and seller parties. This rate can be considered for any and all types of products prevalent in the market ranging from consumer products to real estate to capital markets. It gives the immediate value of the product being transacted.read more plus the premium.Flexible Forward: Under this method, the parties can tend to exchange funds, 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 datesNon-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 later. In this case, the farmer can enter into a forward contractForward ContractA forward contract is a customized agreement between two parties to buy or sell an underlying asset in the future at a price agreed upon today (known as the forward price).read more 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 negotiate the contract terms and are dealt with on a principal-to-principal basis.Most transactions are delivery based.Usually, the products are OTCOTCOver the counter (OTC) is the process of stock trading for the companies that don’t hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more based and are customizable in 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 contracts and do not want to deal directly with the futures marketFutures MarketA futures market is a financial marketplace where participants trade futures contracts for commodities, stock indices, currency pairs, and interest rates at a pre-determined rate and agreed-upon future date. It, thus, protects investors and traders from losing money on a transaction even if the price of the commodity or financial instrument rises or falls later.read more 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 regarding the contract size and 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 a 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. Only forward markets provide such flexibility to customize the forward contracts. At their own will, the parties may decide on the quantity, time, and rate at the delivery time as per their needs and specifications. This gives both parties a lot of conveniences owing to the market’s flexibility options. They are 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 they decide to enter into the contract. If the horizon happens to be for two 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 following their time frame. Because the contracts are 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 with over the counter. Thus, due to their flexibility, huge institutional investors such as hedge fundsHedge FundsA hedge fund is an aggressively invested portfolio made through pooling of various investors and institutional investor’s fund. It supports various assets providing high returns in exchange for higher risk through multiple risk management and hedging techniques.read more prefer to deal with them rather than enter into a standardized futures contract. The counter products allow them the flexibility to suit their strategy, duration, and contract size 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 contractDifficulty 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, a powerful financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more acts as a derivative so that the underlying exposure is fully hedged and 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 are a preferred favorite to deal with in the forward market as they can very well be tailor-made to suit the parties’ requirements.