What is a Forward Market?
A forward market is a marketplace that offers financial instruments that are priced in advance for future delivery. It tends to be referenced as the foreign exchange market, but it can also apply to securities, commodities, and interest rates.
- Forward markets facilitate the exchange of forward and futures contracts, setting the price of a delivered asset or financial instrument.
- Forward contract pricing is based on the difference in interest rates between two currencies being traded, particularly within FX. Otherwise, it would be based on the yield curve.
- Forward contracts differ from futures because they are customizable on offer size and maturity date, while futures tend to be standardized.
How a Forward Market Works
Forward markets create forward contracts. The forward contracts are meant to be used for speculative purposes, as well as for hedging. Forward contracts are transacted between banks and banks to customers.
The forward market offers both forward and futures contracts. The two differ in that forward contracts can be customized to the holder’s requests, whereas futures contracts tend to be standardized regarding maturity and order size.
A forward contract allows a party to buy or sell an asset at a predetermined price within a specified time in the future. Forward contracts can be customized to a commodity, delivery date, and order size. Commodities can include grains, natural gas, oil, precious metals, and more. Based on the contract, a forward settlement can either be a recurring monthly cash payment or on a once-delivered basis.
For example, Sam wants to buy gold to diversify his portfolio and hedge himself against any downside from the S&P 500. At the moment, gold is $2,000 per ounce. He believes gold will skyrocket in one year to $2,500/oz and decides to enter into a position with a gold producer, with an asking price of $2,000/oz one year from now.
It means the gold producer must give Sam his gold in one year for the price of $2,000/oz regardless of what the market price is then. The payment can be conducted on a predetermined basis, whether that may be monthly, quarterly, yearly, or when the goods are delivered.
Forward contracts are known to be OTC (over-the-counter) instruments, since they are not traded on a centralized exchange. That being said, they are exposed to a higher degree of default risk but also offer a higher potential return.
A futures contract refers to an agreement that allows a party to buy or sell an asset at a predetermined price within a specified time in the future. Futures are standardized contracts, particularly in the quantity of ordering size and date.
Buyers who enter a futures contract are obligated to buy the goods from the seller based on what is written in the contract when the delivery date arrives. Vice-versa, the seller is obligated to sell the goods to the buyer on the delivery date based on the price written in the contract, regardless of what the market price is on the exchange date.
How Forward Markets Price Contracts
Within the forward market, contracts are priced based on interest rates. For example, in the foreign exchange market, forward prices stem from the difference in interest rates between two currencies.
The value is then applied over from the transaction to the settlement date of the contract. Another instance would be interest rate forwards, where the price is derived from the yield curve.
Forwards Not Within the Forward Market
In some cases, there are currencies where there is no standard forward market to trade upon. Such an entity is known as a non-deliverable forward. Often, the contracts are executed offshore, implying that they are conducted outside the domestic market to reduce trading restrictions.
In addition, they are only executed as swaps and are cash-settled in either euros or dollars. Generally, the most commonly traded currencies of such nature are won from South Korea and the rupee from India.
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