What exactly is a forward market?
The forward market is an over-the-counter marketplace that determines the price of a financial instrument or asset for future delivery. Forward markets trade various instruments, but most think of the foreign exchange market. This concept also applies to securities, interest rates, and commodity markets.
Forward markets work
A forward market creates forward contracts. Like futures contracts, forward contracts may be used for hedging and speculating, but several vital distinctions exist. Forward contracts are customizable to meet customer needs, whereas futures contracts include set attributes such as size and maturity.
Banks and customers execute forwards, whereas exchanges execute futures. Forwards are desirable in the forex market due to their flexibility.
Pricing
The forward market prices are dependent on interest rates. The foreign exchange market calculates the forward price from the interest rate differential between the two currencies from the transaction date to the contract settlement date. The yield curve to maturity determines interest rate forward prices.
Foreign Exchange Forwards
Prices and trades in interbank forward forex markets are swaps. Currency A is bought vs. currency B for delivery on the spot date at the market spot rate. The interchange initiates currency A vs. B at the original spot rate plus or minus the forward points at maturity.
Most interbank deals are for a week or month from the spot date. Also, most markets have three- and six-month maturities, but after 12 months, liquidity decreases. Most amounts are $25 million or more, sometimes billions.
Customers, including companies and financial organizations, like hedge funds and mutual funds, can conduct forwards with a bank counterpart as swaps or outright transactions. Outright forwards buy currency A vs. currency B for delivery on the maturity date, any business day after the spot date. The price is the spot rate plus or minus the forward points, but no money changes hands until maturity. Outright forwards can be any size and have odd dates and quantities.
Undeliverable Forwards
Trade non-deliverable forwards for currencies without a typical forward market. These swaps are cash-settled in dollars or euros and conducted offshore to evade trading limitations. The most traded coins are the Chinese renminbi, the South Korean won, and the Indian rupee.
Conclusion
- Forward contracts are configurable in size and maturity period, unlike future contracts.
- Interest rate differences determine forward contract pricing.
- Euro/USD, USD/JPY, and GBP/USD are the most traded currencies in the forward and spot markets.
