What is a Forward market?

A forward market is a market that trades in over-the-counter derivative products and so agrees to take delivery at a certain price and time in the future. Furthermore, the contract may be adjusted in terms of the pricing, quantity, and date.

The forward market sets the price of assets and financial devices for future delivery and is used for financial instrument trading. In other words, it is the market where we can sell and buy financial instruments and assets for future delivery.

The forward market is the market for determining the price and selling and acquiring forward contracts, financial instruments, and assets. A market like this is used for trading instruments. It allows contract parties to customize the time, amount, and rate at which the contract will be performed. 

How does a Forward Market work?

The buyer and seller’s outcome determines the current price of commodities. If the per bushel price is the same as the set contract price at the moment of sale, the contract is fulfilled. If the contract expires and the spot price rises, the seller must pay the difference between the forward and spot prices. If the forward price falls below the spot price, the buyer must pay the difference.

When the contract expires, the conditions must be followed. The terms of each forward contract may differ. These derivatives are not traded on an exchange in the same way that stocks are. They are, instead, over-the-counter investments. As a result, they are largely employed by institutional investors, like hedge funds or investment firms, and are less available to average retail investors.

A forward contract can be settled in two ways: by delivery or by monetary basis. If the contract calls for delivery, the seller must provide the underlying item or goods to the buyer. The purchaser then pays the agreed-upon payment in cash to the vendor. When a contract is concluded on a cash basis, the buyer pays on the settlement date, but no assets are transferred. The difference between the current spot price and the future price determines the payment amount.

Features of Forward Market

The following are the characteristics of the forward market:

• The price of delivery  is the forward price 
• The demands and requirements determine the contract size.
• The contract is settled on the date mutually agreed upon by the parties.
• All contract conditions are agreed upon by the parties.
• All transactions in such a market are conducted over the phone with a specific broker.
• All transactions are conducted based on the principal-to-principal principle.
• All participants should assess the credit risk and keep the credit limit for all opposing parties.
• If a transaction is made through a broker, a commission is paid to both the buyer and the seller; otherwise, no commission is charged.
• Participants generally negotiate with one another. However, certain contracts are entered into through one or more dealers.
• There is no financial transaction until delivery. However, non-dealer consumers may be forced to make a modest margin deposit in rare situations.
• Trading in such a market is generally uncontrolled.

Importance of Forward Market

Customization – In a forward market, parties may enter and determine on their own the amount, timing, and rate at the delivery time based on their need and specification. It is extremely adaptable and handy for both parties.

Provides full hedge – It is highly beneficial for parties with certain products they need to trade in the future. The forward market offers a full hedge and attempts to prevent numerous risks, allowing the parties to protect their commitments.

Over-the-counter items – Most products are traded over the counter in the forward market. The majority of institutional investors choose to deal with firms rather than enter into future contracts. Over-the-counter goods provide them with the ability to tailor the length, contract size, and approach to their own needs.

Exposure matching – The parties can now match their vulnerability with the time frame of the duration in which they can engage in the contract. Based on this, they may adjust to every party’s needs and change the duration.

Benefits of Forward Market

• When a seller has goods to exchange in the future for which the cost is unclear, or when an exporter wants to lock in the rate of exchange at which the money must be collected, he can do so in the forward market by engaging in such contracts.
• At times, one party may be unwilling to enter into such deals through futures since the contract’s terms and conditions are adequately described and standardized. Only forward markets give such freedom to create forward contracts. The parties may decide on the amount, timing, and pricing at the time of delivery based on their needs and specifications.
• Because of the flexibility and customization features, the parties may now match their risk with the time frame of the phase they chose to engage in the contract. Because the contracts are tailored to the parties, they may be altered to suit any party and change the duration.
• Because the products are often traded over the counter, financial institutions such as hedge funds prefer dealing with them rather than entering into a conventional futures contract.

Conclusion

The forward market is a market where financial instruments and assets are traded. The forward market makes it possible to swap forward and future contracts. Forward contracts can be tailored in terms of size, duration, length, and rates. The price of a forward contract is dependent on the difference in interest rates between the two economies in which the contract is formed. It might be tough to locate a willing counter-party at times. Because of the inefficiencies and difficulties of the forward contract, some parties take steps to breach the contract. The forward contract differs from the futures contract in that these contracts are created based on the offer’s magnitude, timing, and conditions.

Frequently Asked Questions (FAQs)