Forward Market

Forward Market refers to a market that deals in over-the-counter derivative instruments and thereby agrees to take delivery at a set price and time in the future. In addition, the contract can be customized regarding the rate, quantity, and also about date.

The forward markets are mostly used in the context of foreign exchange market besides the standard securities market or commodities dealings. The prices of the assets in the forward market are purely interest-based.

• The forward market is an Over-the-Counter arena where participants trade derivative instruments. They agree to buy these instruments at a fixed price on a predetermined future date. The contracts are tailored, specifying rate, quantity, and date.
• Trading in the forward market involves private negotiation through phone communication between parties and brokers. Transactions are often delivery-based, particularly for customizable products in the Over-the-Counter domain. Typically, forward markets lack extensive regulation.
• Forward markets entail the physical delivery of assets, in contrast to futures contracts, which settle in cash.

Forward market refers to the market that makes available forwards contracts to investors who want future delivery of assets with the price being fixed for the delivery today. The best thing about these markets is that they make the contracts flexible to fit into the requirements of customers.

Forwards, a powerful financial instrument 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.

These contracts follow interest-based pricing method. However, the pricing of an asset in the forward market in foreign exchange sphere is determined by the difference between the interest rates applicable in two currencies in questions.

Forwards market can easily be identified, given the unique features they have. Some of the characteristics trait that they possess are listed below.

Let us have a quick look at them:

• 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 OTC based and are customizable in quantity, delivery dates, and price.
• It is generally not regulated by anybody.

The types of forward market that exist in the financial sector are as follows:

• 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 rate 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 dates
• Non-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

Let us consider the following instances to understand the forward market definition better:

Example 1

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 contract 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.

Example 2

In September 2023, the Bangladesh Bank decided to fix the foreign exchange rate itself for the US dollars to guide the forward market. The authorities took this step after observing the forex crisis with the banks specifying different rate to different firms for dollar-driven forward purchases.

With this step taken, the difference in the forward rate for different firms would be controlled, thereby establishing a platform that ensures impartial forward contracts dealings in the foreign exchange market.

A forward market helps people deal with forwards contracts, which allow traders to both hedge and speculate. The significance of these markets, however, have been mentioned pointwise below:

• 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 market 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.

A forward market has its own set of pros and cons that anyone dealing in forwards must be aware of.

Let us have a look at the benefits and limitations of these markets below:

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 funds 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 contract
• Difficulty 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.

Forward market and future market are two places where the traders and investors try their luck. However, before one invests in either of them, they must be aware of both these types of markets to know the benefits they may expect and the risks that they might get exposed to when investing there.

Some of the differences between the two are as follows:

• 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.

This has been a guide to what is Forward Market. We explain it with its examples, features, vs future market, types, advantages, disadvantages and importance. You can learn more about accounting and financing from the following articles –

• Forward Rate Agreement
• The formula of Forward Rate
• Forwards vs. Futures
• What is Managed Futures Strategy?