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Forward Market: Definition, How it works, and Different Types          

Forward Market: Definition, How it works, and Different Types

Forward Market: Definition, How it works, and Different Types

A forward market is an over-the-counter financial marketplace where contracts for future delivery are priced in advance. Forward markets are used for trading a wide variety of assets, like stocks, bonds, debts etc. although the word is most often associated with the foreign exchange market. 

The forward market works by creating futures contracts. The forward market serves important roles, one of the most important of which is to reduce risk and establish a price for an asset or financial instrument that will be used in the future.

A person who wishes to limit risk and fix the price of any asset or financial instrument may enter into a contract via the forward market. Such a person has the option to engage in such a contract. Contracts for the future and the future itself are available in the forward market.

Forward contracts is traced back to ancient times, with evidence dating as early as 2000 BCE in Mesopotamia. Due to transportation challenges, business was often conducted based on samples, making advance contracting essential.

There are four types of forward markets. They are flexible forward markets, closed outright forward markets, non-deliverable forward markets, and long-dated forward markets. 

What is Forward Market?

A forward market is an over-the-counter financial marketplace where future delivery contracts are bought & sold at a marketplace for the buying and selling of forward contracts for the purpose of either hedging or speculating. In India, both the forward markets and the futures markets are governed by the Forward Markets Commission.

How Forward Market differ from Stock Market?

Forward markets and stock markets each serve different functions and have distinct participants, with the former typically used to hedge against price risks resulting from future price movements while the latter serves to form capital and invest it. Participants of each market include producers, consumers and speculators in the forward market whereas investors, brokerage houses, fund managers and stock exchanges comprise its participants on either end.

Forward markets trade contracts for commodities, currencies, and other underlying assets while stock markets trade shares of publicly listed companies. Pricing in the forward market depends on factors like supply and demand, cost of carry, and convenience yield, while stock prices can be influenced by earnings, growth potential dividends and investor sentiment.

Liquidity in the forward market tends to be lower due to customized contracts. But stock markets offer higher liquidity due to standardised stocks which can easily be traded. Also, forward markets have less stringent regulations than highly-regulated stock markets.

Settlement in the forward market usually entails the physical delivery of an asset while stock settlements require cash payments on the settlement date. Volatility tends to be less frequent on forward markets compared with fluctuations in stock prices on traditional markets such as Wall Street.

How does the Forward Market work?

Forward markets work by creating forward contracts. The forward contracts are designed to be used not just for the sake of hedging but also for speculative reasons. Transactions using forward contracts may take place between banks as well as between banks and their clients.

How does the Forward Market work?
How does the Forward Market work?

Both forward contracts and futures contracts may be found in the forward market. The difference between the two is that forward contracts may be modified according to the holder’s requirements, whilst the terms of futures contracts are often set in terms of order size and maturity.

The Forwards Agreement served as the basis for developing the Futures contract, also known as the Futures Agreement. The Futures Contract is meant to preserve the fundamental transactional framework of the Forwards Market. At the same time, it gets rid of the dangers that are connected to the forward’s contract. If you have an accurate directional perspective of the price of an asset, then you will get a financial gain from having a Forward Agreement.

What is the importance of the Forward Market?

The forward market is important as it enables forward contract trade. A forward contract is an agreement between two parties to purchase or sell an item at a certain period at a price that has been agreed upon. This agreement is not standardized.  Contracts secure a fixed price for the future while giving the corporation a measure of control over supply and risk. It can protect against fluctuations in exchange rates and interest rates. Contracts may be tailored to fit any circumstance. It may aid in the forecasting of money coming in.

Agreements may help businesses plan investments by allowing them to secure capital and begin earning returns on those funds far in advance of the contract’s payment due date.

What are the types of Forward Markets?

The four types of forward markets are flexible forward markets, closed outright forward markets, non-deliverable forward markets, and long-dated forward markets. The parties to a flexible forward may agree to make a cash exchange on or before the maturity date.

The exchange rate in a closed outright forward is predetermined at the time of the transaction and is the sum of the spot rate plus the premium.

In a non-deliverable forward, neither party takes physical possession of the underlying asset; instead, they agree to pay the spread between the spot and exchange rates at a later date. Long-dated forwards are quite similar to short-dated contracts, except that the latter often have shorter maturities.

Non-Deliverable Forward

A non-deliverable forward is a forward outright in which the parties agree, at the start, to pay only the difference in value between the forward rate negotiated and the spot rate two business days before maturity rather than the outright amounts themselves at maturity. To put it another way, the economic impact is the same as if a conventional forward outright had been sold, followed by a balancing spot trade two days before maturity.

Long-Dated Forward

Any forward contract with a settlement date of more than one year out is considered a long-dated forward. The maturity of certain long-dated futures may extend to ten years in the future. This agreement is entered into today for the purchase or sale of a certain asset (commodity, currency, etc.) at a price agreed upon today, with settlement occurring on a date farther in the future than one year from today.

 Close Outright Forward

A closed forward contract is an agreement to purchase or sell a certain quantity of one currency in exchange for payment in another currency at a future date known as the ‘value date’.  On the other hand, a forward contract is considered “open” if the parties involved can swap the money before the valuation date.

The “closed outright forward,” also known as a “fixed” or “standard” contract, is the most basic kind of forward agreement. Companies employ them to protect themselves against potential financial losses caused by fluctuations in currency exchange rates. However, it is hard to profit from favourable exchange rate fluctuations while hedging using closed outright forwards.

As with other types of closed forwards, the settlement date in closed outright forwards cannot be changed. The parties are legally required by law to make the exchange on the value date. Open or “flexible” forward contracts may be preferable for businesses that want greater leeway in terms of payment.

Who regulates Forward Market in the U.S.?

The Commodity Futures Trading Commission (CFTC) was established by Congress in 1974 with the main objective of overseeing commodity futures and options markets in the United States. The CFTC aims to protect users, participants, and the general public from fraud, manipulation, abusive practices, and systemic risk related to derivatives covered by the Commodity Exchange Act.          

The CFTC supervises forward markets for a range of assets, including agricultural commodities, metals, energy, currency markets, and financial futures and options. Its key responsibilities encompass various aspects of market oversight and regulation. These include overseeing derivatives exchanges such as the Chicago Mercantile Exchange (CME) and Intercontinental Exchange (ICE), reviewing and approving new futures and options products before trading, and monitoring trading activities and large trader positions to maintain market integrity.

The CFTC also enforces laws and regulations, such as position limits, registration requirements, and disclosure rules. It also closely monitors market activities to detect any evidence of price manipulation, fraud, or other invasive practices that could disrupt trading. The CFTC exercises oversight over self-regulatory organizations like the National Futures Association (NFA).

Who regulates Forward Market in India?

Forward Markets Commission (FMC), established under the Forward Contracts (Regulation) Act of 1952, oversees and regulates forward market intermediaries such as commodity exchanges and commodity brokers.

The Forward Contracts (Regulation) Act allows the Futures and Options Market Committee (FMC) to oversee forward trading of commodities permitted under its purview, such as agricultural commodities, metals and precious stones. One of its primary responsibilities is setting conditions for trading forwards, options, futures on commodities involving aspects like contract specifications, position limits and margin requirements.

The FMC implements measures such as price dissemination, surveillance, auditing and resolution of disputes related to violations of Forward Contracts Act and related rules. They take appropriate disciplinary actions against violators.

FMC plays a pivotal role in supporting and regulating India’s forward market, including authorizing new exchanges, contracts and participants as well as providing advice to government on issues related to commodity forward markets. The commission collects and maintains records pertaining to India’s forward commodity markets ensuring a comprehensive yet well-regulated marketplace for commodities trading in India.

How does the Forward Market sets the price of assets or financial instruments?

The forward market helps in price discovery and setting future prices of assets and financial instruments. Buyers and sellers enter into contracts to buy or sell an asset at a specified price for delivery at a future date. The forward price is determined based on the expectations of future spot price at the delivery date. Several factors influence forward pricing.

First, the current spot price of the underlying asset provides a reference point for the forward price. The forward price usually trades at a premium or discount to the spot price based on interest rates and storage costs.

Second, the expectations about future supply and demand determine whether the forward price will be higher or lower than the spot price. The demand for an asset is expected to increase in the future leads to higher forward prices. Higher expected supply results in lower forward prices.

Third is the cost of carry, which includes costs like storage, insurance and interest expense, impacts the forward pricing. The forward price must be higher than the spot price to cover the cost of carry and make the contract worthwhile.

Finally, the time remaining to contract expiration plays an important role. Forward prices generally converge to the expected spot price as the delivery date approaches. Longer the time to expiration, greater is the uncertainty and volatility in forward prices.

What are the benefits of the Forward Market?

The forward market is key to an economy with many benefits. Below are four main benefits.

  1. Price discovery

The forward market helps in price discovery and price risk management. The forward prices reflect the expectations of market participants about future spot prices. This helps producers, consumers and traders to hedge their price risk and make better-informed business decisions.

  1. Liquidity 

The forward market increases liquidity in the underlying spot market. The ability to hedge price risk makes the spot market more attractive, which boosts trading volumes and makes markets more liquid. This enhances the allocative efficiency of the spot market.

  1. Allocation of resources

The forward market facilitates efficient allocation of resources. With better price discovery and risk management, resources can flow into the production and consumption of goods and services based on real market signals rather than being distorted by price risks. This improves welfare and optimizes resource allocation.

  1. Investment opportunities

The forward market provides more investment and financing opportunities. When price risks are hedged, producers and traders are more willing to make long-term investments in production, storage and transportation of commodities. Financial institutions are also more open to providing funding when risks are managed.

The forward market plays an important role in enabling efficient price discovery, risk management, resource allocation and investment in an economy. It reduces uncertainty, boosts confidence and spurs economic activity. A robust forward market is a sign of a well-functioning economy.

What is Forward Market hedging?

Forward market hedging is a strategy that utilizes forward contracts to reduce risks arising from adverse price movements in the future. A forward contract allows two parties to agree upon an exchange price for an asset at some future date based on interest rate differences between currencies entering into an agreement. Producers, importers and other buyers use forward contracts to secure input prices for future production or purchases and reduce risks associated with rising prices.

Exporters and sellers use them similarly, to lock in exchange rates for future sales receipts – offering protection against falling prices or currency depreciation. Speculators who anticipate future price movements also participate in the forward market by taking opposite positions from hedgers and thus contributing to greater liquidity and completeness within it.

Forward hedging provides price certainty, helping producers and consumers secure input and sales prices, and mitigating future cash flows and budget risks. However, forward hedging does not come without risks: exchange rates or prices could move in the hedger’s favour, incurring opportunity costs while counterparty risks could surface if someone defaults.

What is an example of a Forward Market?

An example of a forward market contract is best explained in a daily life scenario. Consider the scenario of a farmer who produces a certain crop but is unsure about the price of that crop three months later. In this scenario, the farmer can enter into a forward contract with a third party to secure the price at which he will sell his crop over the course of the subsequent three months. The market for such a transaction is called the forward market, which is the name given to the market.

Is the Forward Market risky?

Yes, the forward market comes with risks even when it is a tool designed to mitigate risk. The most important is the regulatory risk here. No regulatory entity oversees the forwards contract and the agreement it creates. It is legally binding since both parties to this contract agreed to its terms before it was enacted.

Due to the absence of a regulating body, there is a greater possibility that any of the parties may fail in their obligations. Additionally, in the event that even one of the parties engaged does not honour the terms of the contract, the business transaction will not be finalized. This kind of risk is referred to as counterparty risk.

The predicted loss on a forward contract is calculated by multiplying the theoretical amount of the contract by the value of the contract, which is then multiplied by the likelihood of the contract going into default.

The buyer runs the risk that the seller will not produce the underlying asset when the contract is finally settled when the value of the contract is positive,

The buyer runs the risk of not purchasing the underlying asset when the contract is settled When the value of the contract is positive, putting the seller in jeopardy.

Is Forward Market very common?

Yes, forward markets are very common. They are used to hedge against risk and to speculate on future price movements. Forward markets are typically used for trading in foreign currencies, commodities, and interest rates.

What is the difference between Forward Market and Future Market?

The main difference between forward markets and futures markets is that forward contracts are traded over-the-counter (OTC), while futures contracts are traded on exchanges.

Below is table of comparison.

Forward MarketFutures Market
Contract Type
Customized contractsStandardized contracts
Trading
Over-the-counter (OTC)Organized exchanges
Counterparty Risk
Higher, no clearinghouseLower, with clearinghouse
Liquidity
Generally lowerGenerally higher
Settlement
At contract maturityDaily mark-to-market
Regulation
Less regulatedMore regulated
Flexibility
More flexibleLess flexible

What is the difference between Forward Market and Spot Market?

The main difference between a forward market and a spot market is the timing of the transaction. Below is a detailed tabular comparison.

FeatureForward MarketSpot Market
DefinitionA forward market is a financial market where contracts are made to buy or sell an asset at a specific price on a future date.A spot market is a financial market where assets are bought or sold for immediate delivery, typically within two business days.
ContractForward contracts are customized, privately negotiated agreements between two parties to buy or sell an asset at a specified price on a future date.Spot transactions involve the immediate exchange of assets at the current market price.
DeliveryDelivery of the asset takes place on a future date specified in the contract.Delivery of the asset takes place almost immediately, typically within two business days.
SettlementThe settlement of the contract occurs on the specified future date, either through physical delivery of the asset or cash settlement.The settlement of the transaction occurs shortly after the trade, typically within two business days.
PurposeForward markets are primarily used for hedging risk and planning future transactions. They help protect against fluctuations in asset prices and exchange rates.Spot markets are used for immediate transactions and provide liquidity for market participants. They help participants take advantage of current market prices.
Counterparty riskHigher counterparty risk, as the contracts are not standardized and are negotiated privately. The risk of one party defaulting on the contract is higher.Lower counterparty risk, as transactions are settled quickly. Additionally, many spot market transactions are conducted through regulated exchanges, providing a more secure trading environment.
Price discoveryForward market prices are based on expectations about future asset prices, interest rates, and other factors. They may not always accurately reflect the current market price.Spot market prices reflect the current supply and demand for an asset, providing real-time price discovery.
RegulationForward markets are typically less regulated than spot markets, as they involve private transactions between parties.Spot markets are often regulated, with transactions conducted through exchanges that have specific rules and oversight.
FlexibilityForward contracts are customizable, allowing parties to tailor the terms to their specific needs.Spot transactions are standardized and less flexible, as they involve the immediate exchange of assets at the current market price.

Is Forward Market allowed in India?

Yes, forward markets are legal in India. Currently, forward trading in 113 different commodities is governed by a total of five different national exchanges. These exchanges are the Multi Commodity Exchange, the National Commodity and Derivatives Exchange, the National Multi Commodity Exchange, the Indian Commodity Exchange Ltd., and the ACE Derivatives and Commodity Exchange.

In addition, the Forward Contracts (Regulation) Act of 1952 established 16 commodity-specific exchanges that are recognized to regulate trading in a variety of commodities. The Forward Markets Commission, sometimes known as the FMC, regulates the commodities market.  Its headquarters are in Mumbai.

The Forward Markets Commission (FMC) is the primary regulatory body for India’s futures and forward markets. Because food commodities have historically been the focus of futures trading in India, the FMC operates under the Ministry of Consumer Affairs, Food, and Public Distribution supervision.

The Forward Contracts (Regulation) Act of 1952 established the FMC as a legally recognized entity. The Act stipulates that the Commission must have a minimum of two members and a maximum of four members, all of whom must be chosen by the Central Government. The federal government is responsible for making the selection of the FMC chairman.

What is the difference between Forward Market and the Stock Market?

A stock market is a network of stock exchanges where traders and investors buy and sell shares of publicly listed corporations. A forward market is an over-the-counter marketplace that establishes the price of a financial instrument or asset for future delivery.

Position traders make their judgments based on the idea that if a trend has already begun, there is a good chance that it will continue. They trade in accordance with the direction of the trend and make use of fundamental and technical studies in order to get a larger portion of the available market profit.

Position trading is the antithesis of day trading in terms of strategy, but it is also quite different from swing trading in many other respects. Position traders hold onto their holdings for an even longer period of time than swing traders. This is how they accomplish that goal.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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