A forward market is an over-the-counter (OTC) marketplace for foreign exchange, interest rates, and commodities. It does not involve a stock exchange. This indicates that trading in forward contracts does not occur on established stock exchanges. Instead, direct trading takes place between traders for these contracts. It's fascinating, isn't it? Let's understand what the forward derivatives market is and how it works in this article.
Forward contracts are the types of derivatives that enable a trader to buy or sell a particular asset at a specific price within a defined time frame set in future. Forward contracts are flexible and offer a great deal of customisation in terms of the assets, delivery dates, and order size.
You can trade oil, grains, precious metals, natural gas, and a number of other things in a forward contract. Based on the contract, the settlement may include a one-time or recurring monthly cash payment after the delivery of products.
The Indian forward market operates by enabling parties to enter into contracts to buy or sell a specified commodity at a predetermined price at a future date. In the forward market, two parties agree upon the contract's conditions, including the asset's cost and delivery date. The transaction takes place when the buyer pays the sellers at a mutually agreed time and price. Normally, SEBI and RBI are in charge of regulating the forward market in India. The forward market in India is also bound by a number of laws and regulations.
These include margin requirements and position limitations. This is to reduce the risk of defaults by the concerned parties in a contract. Businesses, hedge funds and even people take part in India's forward market. These parties employ forward contracts to safeguard themselves against price fluctuations in a range of markets, including the currency, commodity, and interest rate markets.
Let’s now understand the working of forward contracts through an example. Let's suppose Rakesh wants to purchase gold to diversify his holdings and protect himself if the Nifty 50 declines. Gold currently costs Rs. 2,000 per kg. He decides to enter into a position with a gold manufacturer at an ask-price of Rs. 2,000/kg after a year. This is because Rakesh anticipates the price of gold would rise to Rs. 2,500/kg.
This indicates that regardless of the market price at that time, the gold producer must provide Rakesh's gold in a year for the price of Rs. 2,000/kg. He can make the payment on a predetermined schedule. This may be monthly, quarterly, annually, or even after the delivery of products.
Here are some other reasons why the forward market is crucial to the stock market.
Certain businesses and individuals find that hedging their forex contracts greatly reduces future uncertainty.
It aids the players in determining the exchange rate for the assets and financial contracts.
It is very beneficial to secure the contract and receive/pay a specific amount at a later time.
It is also highly useful for individuals who want to customise their contracts.
The forward market and the future market are very different from one another.
1. Price Range
A participant is only exposed to a certain amount of daily price movement since the futures in share market have a maximum daily price range for each day. However, there is no daily price cap on forward contracts.
Forward contracts are available from banks for delivery on any day. However, the stock exchanges offer predetermined and fixed dates for futures contracts. For instance, currency futures contracts are available for delivery in India on the fourth Thursday of the month.
3. Size of Contract
The forward market offers contracts for particular amounts of currencies tailored to specific needs, whereas the futures market only offers standardised contracts in predetermined amounts.
Less than 2% of futures get settled contracts by actual deliveries. Whereas more than 90% of forward contracts get delivered.
A forward trade takes place directly between banks and their clients. On the contrary, stock exchanges regulate futures trading.
6. Credit Risk
If the seller or buyer defaults, the clearing house of the futures market promises to acquire the currency or deliver it as scheduled. However, a brokerage firm that trades in the forward market needs to be certain that a party is creditworthy.
Futures markets allow speculative trades as many brokers facilitate it. However, traders mostly used forward contracts for hedging rather than speculation. Although speculation is possible in the forward market, it is less favourable.
Every futures contract requires a security deposit (margin), while forward transactions are exempt from this. In the forward contracts, compensating balances are necessary that act as collaterals.
In the futures market, intermediary charges depend on both the brokerage costs and individually negotiated rates. The "spread" between a broker's purchase and sell prices determines the commissions for intermediaries in the forward market.
While forward contracts are traded over the phone, futures contracts are traded in a competitive environment.
Here are the noteworthy benefits offered by the forward market.
Offers complete hedge: These contracts provide a hedge and make every effort to continue avoiding uncertainties so that parties can be certain of the payment rates. For instance, an exporter can use forward contact if they want to lock in the exchange rate at which the payment must be received. Or when a specific seller has certain commodities to exchange in the future for which the price is uncertain.
Customisation: Due to the clear and uniform terms and conditions of the contract, there are situations when one party may not be prepared to enter into such contracts through futures. Only forward markets offer such customisation options for forward contracts. The parties may choose the quantity, time, and price for the delivery at their discretion based on their requirements and preferences. Due to the variety of possibilities, this benefits both parties greatly. Since they are produced just for the parties, they can be altered for any time and quantity.
Matching of exposure: The parties can match their exposure to the length of the term they want to enter into a forward contract. The parties can sign into such contracts as per their desire so that their exposure is hedged after their time frame. For instance, they can choose a two-month horizon rather than the standard three months. One can modify the contracts and change the terms because they are tailor-made specifically for the needs of traders.
Over-the-counter products: These products typically trade beyond the scope of stock exchanges. Therefore, large institutional investors like hedge funds prefer to work with them due to their flexibility. They prefer them over a standardised futures contract. They enjoy the freedom to customise their strategy, time frame, and contract size to meet their specific requirements.
The following are some limitation of the forward market.
Cancellation Issues: Sometimes, it is not possible to terminate the contract after signing it. So, the parties frequently default since they are not subject to the same regulations as futures contracts.
Difficulty in finding a counterparty: Finding a comparable counterparty to enter into the forward contract with may be challenging because they are OTC products at times.
A forward contract is an over-the-counter derivative that has a predetermined expiration date and price. Trading for this unique financial instrument entails in the forward market. Traders obtain the right as well as an obligation to settle contracts. The majority of trading occurs over the phone through negotiations between parties and brokers.
They are mostly delivery-based transactions, especially in the case of customised over-the-counter products. The main distinction between forwards and futures is that the former are unregulated instruments. Any organisation that designs a forward contract may alter the lot size and other specifications to suit their requirements.
In India, the Forward Markets Commission is in charge of managing market regulation for the futures, commodities, and forward contract derivatives in share market.
Transactions in the spot market entail the quick transfer of assets and money. On the contrary, the forward market involves agreements to swap assets and make payments at a later time. Forward contracts are simply commitments to make a delivery in the future.
The asset, the future delivery date (maturity date), the agreed-upon price (forward price), and the quantity of the asset to be exchanged are all specified in forward contracts. They trade over-the-counter (OTC). Moreover, traders can modify the terms of contracts.
Supply and demand in the forward market often drive the prices of forward contracts. The prices depend on market sentiments, anticipated future spot prices, interest rates, and other factors.
Hedgers, speculators, and arbitrageurs are the participants in the forward market. Hedgers look to decrease risk, and speculators look to benefit from price swings. Arbitrageurs are those looking to take advantage of price disparities.
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