A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. While applicable to various instruments, the term is primarily associated with the foreign exchange market. It can also be relevant for securities, interest rates, and commodities markets.
Key Takeaways
- Forward contracts differ from future contracts in being customizable in size and length, or maturity term.
- Forward contract pricing is based on interest rate discrepancies.
- The most commonly traded currencies in the forward market are the same as on the spot market: EUR/USD, USD/JPY, and GBP/USD.
The Mechanics of a Forward Market
A forward market leads to the creation of forward contracts. While forward contracts—like futures contracts—can be used for both hedging and speculation, notable differences exist between the two. Forward contracts are customizable to fit a customer’s requirements, while futures contracts have standardized features, including their contract size and maturity.
Forwards are executed between banks or between a bank and a customer; futures are traded on an exchange, which acts as a party to the transaction. The flexibility of forwards significantly enhances their attractiveness in the foreign exchange market.
Pricing in the Forward Market
Prices in the forward market are interest-rate based. In the foreign exchange market, the forward price is derived from the interest rate differential between the two currencies, applied from the transaction date to the settlement date. For interest rate forwards, the price depends on the yield curve to maturity.
Understanding Foreign Exchange Forwards
Interbank forward foreign exchange markets are priced and executed as swaps. This involves purchasing a currency A against currency B for delivery at the spot date at the current market rate. Upon maturity, currency A is sold against currency B at the original spot rate, adjusted by forward points. This takes place when the swap contract is initiated.
Typically, the interbank market trades for straightforward dates, such as a week or a month from the spot date. Common maturities are three and six months, although liquidity usually diminishes beyond 12 months. Transaction amounts generally start at $25 million and can rise into the billions.
Customers—including corporations and financial institutions such as hedge funds and mutual funds—can execute forwards with a bank counterparty either as swaps or outright transactions. In an outright forward, currency A is bought against currency B for delivery on the maturity date, which can be any business day beyond the spot date. Here, the price includes the spot rate and forward points, but no payments occur until maturity. Outright forwards often feature odd dates and varying amounts suitable for any size.
Exploring Non-Deliverable Forwards
For currencies where no standard forward market exists, non-deliverable forwards (NDFs) offer an alternative. NDFs are executed offshore to bypass trading restrictions, only traded as swaps, and are cash-settled in major currencies such as dollars or euros. The most commonly traded NDF currencies include the Chinese renminbi, South Korean won, and Indian rupee.
Related Terms: Financial instrument, Commodity, Future contracts, Hedging, Speculation, Contract size, Interest rate
References
- CME Group. “Futures Contracts Compared to Forwards”.
