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 and it is used for the trading of financial instruments, in the simple words, the market where we can sale and purchase financial instruments and assets for the future delivery is known as forward market.
The market which is used for determining the price and used for the sale and purchase of forward contracts, financial instruments, and assets is known as forward market. Such a market is used for the trading of instruments. The forward market provides a customization option to the parties to the contract where they are free to decide the time, quantity, and rate of the contract to be executed.
Features of Forward Price
The features of the forward market are given below-
- In the forward market, the delivery price is the forward price.
- The contract size depends upon needs and requirements.
- The settlement of the contract is made on the date which is agreed between the parties.
- All the terms of the contracts are negotiated by the parties.
- All the transactions of such a market are done by telephone, with a particular broker.
- All the transactions are made based on the Principal to principal concept.
- All the participants should examine the credit risk and maintain the credit limit for all the opposite parties.
- If there is any transaction which is made through a broker, a certain amount of commission is charged from buyer and seller otherwise no commission is charged.
- The participants normally deal with one another but some parties are entered into the contracts through one or more dealers.
- There is no money transaction until delivery but a small margin deposit may be required of non-dealer customers on certain occasions.
- In the forward market, trading is mostly unregulated.
How Does It Work?
The forward market is the market that creates forward contracts. One of the main functions of the forward market is to minimize the risk and fixed the price of an asset or financial instrument for the future period.
When any party wants to minimize the risk and fixed the price of any asset or financial instrument, such a person can enter into a contract through the forward market. The forward market 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 company’s shares is continuously decreasing and he is unsure about the price of such share 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 transaction is made is known as the forward market.
Problems of Forward Market
The forward market has several problems. The main problem of the forward market is “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 with the forward market is flexibility and generality. Normally the contracts which are made in the forward market are fixed, cannot be canceled i.e. there is a lack of flexibility. In this market, the contract is made based on certain terms which are based on the very risky issues.
Why Is the Forward Market Important?
The importance of the forward market is given below-
- It is very helpful for the certain corporation and for the individual to hedge their forex contract to remove the uncertainty of the future.
- It helps the participants to fix the price at which the assets/ financial contracts will be exchanged.
- It 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.
The following are the advantages of the forward market:
- Customization- In the forward market, the parties on their own will, may enter and decide the quantity, time, and rate at the time of delivery as per their need, requirement, and specification. It is very flexible and convenient for both parties.
- Offers full hedge- It is very advantageous for those parties who have certain commodities that they need to exchange in future. The forward market 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 dealt with over the counter. Most of the investor institutional wants to deal with them rather than entering into the future contracts. Over-the-counter, products give them the advantage of the 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 in the contract. On the basis of this, they can customize to suit any party and modify the duration.
The following are the disadvantages of the forward market:
- 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 counter party to enter into a contract.
Thus, the forward market is a market which deals with financial instruments and assets. The forward market facilitates the exchange of forward and future contracts. In the forward market, the contracts can be customized in the terms of 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 to find a willing counter party. The forward market has certain disadvantages and difficulties due to this some parties take the 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.
This is a guide to Forward Market. Here we also discuss the definition and how does forward market works along with advantages and disadvantages. You may also have a look at the following articles to learn more –