Updated July 17, 2023
Definition of Forward Market
The forward market is the marketplace that sets the price of the assets and the financial instruments (Bonds, Swaps, Equity, Cap, Futures, Forward rate agreements, Bills of exchange, etc.) for future delivery.
It is used for trading financial instruments; in simple words, the market where we can sell and purchase financial instruments and assets for future delivery is known as the forward market.
Explanation
It is known as the forward market and is used for determining the price and the sale and purchase of forward contracts, financial instruments, and assets. Such a market uses for the trading of instruments. This provides a customization option to the parties to the contract where they can decide the contract’s time, quantity, and rate.
Features of Forward Price
Below are the features :
- In this, the delivery price is the forward price.
- The contract size depends upon needs and requirements.
- The parties settle the contract on the date agreed upon between them.
- The parties negotiate all the terms of the contracts.
- A particular broker conducts all the transactions of such a market through telephone communication.
- All the transactions are made depending on the Principal to the principal concept.
- All the participants should examine the credit risk and maintain the credit limit for all the opposite parties.
- If any transaction is made through a broker, a certain commission is charged from the buyer and seller; otherwise, no commission is charged.
- Normally, the participants deal with one another in this, but some parties enter into contracts through one or more dealers.
- There is no money transaction until delivery, but non-dealer customers may require a small margin deposit on certain occasions.
- In this, trading is mostly unregulated.
How Does It Work?
It is the market that creates forward contracts. One main function is to minimize the risk and fix an asset’s or financial instrument’s price for the future.
When any party wants to minimize the risk and fix the price of any asset or financial instrument, such a person can enter into a contract through the forward market. It offers forward as well as future contracts.
Example of Forward Market
Mr. A has some financial instruments (Equity/Shares) of a particular company, the price of such shares is continuously decreasing, and he is unsure about the price after 3 months. In this case, he entered into a forward contract with Mr. B by locking the price at which he will sell such shares to Mr. B in the upcoming 3 months. The market in which such a transaction is made is the forward market.
Problems of Forward Market
This has several problems. The main problem is the “lack of centralization of trading, liquidity, and counterparty risk. In the case of the forward market, there is very much difficult to find a similar counterparty who wants to enter into a similar contract. Another problem is flexibility and generality. Normally the contracts made in the forward market are fixed and cannot cancel, i.e., there is a lack of flexibility. The contract is based on certain terms in this market, depending on risky issues.
Why Is the Forward Market Important?
Below is the importance :
- It is very helpful for certain corporations and individuals to hedge their forex contracts to remove the uncertainty of the future.
- This helps the participants to fix the price at which the assets/ financial contracts will be exchanged.
- This is very helpful to secure the contract and receive/pay a certain amount on a future date.
- It is very helpful for those who want customization for their contracts.
Advantages
The following are the advantages :
- Customization- In this, the parties, on their own will, may enter and decide the quantity, time, and rate at the delivery time as per their need, requirement, and specification. It is very flexible and convenient for both parties.
- Offers full hedge- It is very advantageous for parties with certain commodities they need to exchange in the future. It provides the full hedge and tries to avoid various uncertainties by which the party can secure their contracts.
- Over-the-counter products- In the forward market, the products are generally handled over the counter. Most investor institutions want to deal with them rather than enter into future contracts. Over-the-counter, products give them the advantage of flexibility to suit the duration, contract size, and strategy as per their requirements.
- Matching of exposure- Now, the parties can match their exposure with the time frame of the period according to which they can enter the contract. On the basis of this, they can customize to suit any party and modify the duration.
Disadvantages
The following are the disadvantages :
- Cancellation problems- In the forward market, if a contract is entered, it cannot be canceled, and also, being unregulated, there are chances that parties become defaulters.
- Finding counterparty- In the case of the forward market, there is very difficult to find a counterparty to enter into a contract.
Conclusion
Thus, the forward market is a market that deals with financial instruments and assets. The forward market facilitates the exchange of forward and future contracts. In the forward market, the contracts can customize in size, duration, length, and rates. In the forward market, the pricing of the forward contract is based on the difference in the interest rate between the two currencies in which the contract is made. Sometimes there are some difficulties in finding a willing counterparty. The forward market has certain disadvantages and difficulties. Due to this, some parties take action to break the contract. The forward contract is different from the future contract because these contracts are made on the basis of offer size, time, and terms.
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