What is the Forward Market?
Aug 3, 2022
The forward market is the market in which forward contracts are traded. As an over-the-counter market, the forward market consists of an informal decentralised network of dealers and customers who arrange forward contracts (also known as forward trades) with one another.
Rather than there being any formal exchange on which trading takes place like there is with say the London Stock Exchange, trading in the forward market is done on an ad hoc basis. If a company comes to Bound in London, for example, to take out a business-related forward trade, they are trading in the forward market. Similarly, if a private investor goes to a different forward trade provider in Australia for a completely different purpose, they are also trading in the forward market.
What most people are referring to when they mention the forward market is the forward foreign exchange market. This is the market for forward contracts for currency exchange. While this is the most well-known sector of the forward market, the forward market also covers forward contracts for trading alternative financial instruments and assets as well.
Bound specialises in providing the means through which businesses that operate internationally can prevent themselves from being negatively affected by changes to the exchange rate. One of the basic services that we provide is forward trades and, as such, we are active participants in the forward market.
What is a Forward Contract?
What is traded in the forward market is forward contracts. These are contracts under which one party will agree to sell a set quantity of something for a set price at a certain point in the future. They are used to lock in the price of a trade that will take place in the future.
After a forward trade is agreed to, both sides are committed to completing the exchange that they have arranged. If, when the time comes to complete the exchange, the current market rate for whatever is being traded has changed, this will not have an effect on the deal. The agreed exchange will take place, nonetheless.
What are Forward Contracts Used For?
Forward contracts can be used for speculation, where risk is taken with the intention of making a profit. However, ironically, they can also be used for hedging purposes. This is where they allow risk to be avoided.
The most obvious use for forward trades is speculation. If someone is able to correctly predict how the price of something that is traded in a forward trade will change over time, they will be able to benefit as a result.
If, using a commodity forward trade, for example, a speculator is able to buy a commodity at below the market rate in the future they will be able to profit from the price disparity between the forward trade price and the future current market rate.
Say a trader takes out a forward trade to buy a certain quantity of coffee for a certain price at a certain time in the future, they will benefit if the price of coffee increases in the meantime. If the price of coffee does increase between the time they take out the forward trade and the time they complete it, they will make a profit. The forward contract will guarantee them the right to buy low and they will be able then to sell high at the market rate for a profit.
Obviously, the trader will be taking the risk that the price of coffee could fall in the meantime.
What is less immediately obvious is that forward trades can be used to avoid risk. Forward trades provide a hedge against risk by providing an alternative to waiting to trade something at the current market rate in the future.
If someone is forced to wait to trade something at whatever the current market rate turns out to be in the future, there is a risk that the price will change adversely.
Going back to the example of coffee prices, we can see how a forward trade could be used to avoid risk.
Say the seller in our example contract was a coffee producer, they may be using the forward contract to guarantee a profitable price. If they knew that the price set out in the forward contract guaranteed them a good profit, they may opt to take the forward trade rather than risk a loss. While they would not be able to take advantage if prices rose, they would still be guaranteed a profit and would avoid risking what could otherwise be a loss.
How Do Currency Forwards Work?
Currency forwards work in the same way as all other forward trades do. It is just that what is being traded in a currency forward is currencies.
Under a currency forward contract, two parties will agree to exchange a set amount of two currencies at a set rate on or before a future date. One party will sell a set amount of one currency for a set amount of a different currency on or before an agreed date in the future. What this does is fix the exchange rate for an exchange of currencies in advance.
As with other forward trades, currency forwards can be used for speculation and for hedging. When used in speculation, a currency trader will look to either buy a currency low or sell it high in the future.
Hedging with currency forwards is known as FX hedging and is the area of currency exchange that Bound specialises in.
Commonly, businesses that operate internationally use forward trades to hedge against any risks that they face from changes to the exchange rate.
If, for example, a company outsources its production to Asia with an agreement to pay their suppliers in US dollars, they will be at risk from adverse changes to the exchange rate taking place between pound sterling (GBP) and US dollars (USD).
Rather than entering into a contract and then waiting to pay its suppliers at the spot rate for GBP/USD, which could change unfavourably, the company can take out a forward trade. The customisable nature of forward contracts means that the company could arrange a currency forward contract that would guarantee a certain exchange rate for GBP/USD, for all of the payments they will need to make.
Rather than risk a change to the exchange rate causing the cost of production to rise, the company will be guaranteed a price because of the rate that is set in the forward trade.
The Forward Market vs The Futures Market
A key aspect of the forward market is that it is a decentralised market, rather than a regulated market that exists on an exchange.
Trading which doesn’t take place on an exchange and happens informally, as with forward contract trading, is known as ‘over the counter’ or ‘off exchange’ trading.
Where forward contracts are traded on exchanges, they work differently and are known as futures contracts. Crucially, over-the-counter forward trades are far more useful in FX hedging than exchange traded futures contracts.
Exchange Traded Futures
Futures trades are the exchange version of forward trades. They provide the same basic contractual agreement between two parties, but the exchanges on which they are traded regulate and standardise the agreements that are made.
Exchange traded currency futures contract will create an agreement between two parties whereby they will exchange a set amount of two specified currencies on or before a certain date in the future. Again, this will lock in the exchange rate for a future date. The difference is that the exchange standardises contracts that are agreed to on the exchange in terms of which currencies are traded, the amounts that can be traded, and the dates by which the exchange must take place.
There are a limited number of possibilities of what type of futures contract can be taken out on a futures exchange. While the exchange rates that are available will vary day to day, two parties who agree to a futures trade will have to choose from a limited number of currency pairings, amounts, and contract completion dates.
The Chicago Mercantile Exchange, for example, which is a major futures exchange, offers futures contracts for GBP/USD which have to be traded in amounts of 62,500 GBP with quarterly settlement dates in March, June, September, and December.
Over the Counter Traded Forwards
Exchange traded futures contracts compare to forward trades which are available over the counter.
With an over-the-counter forward trade, it is possible for the two parties involved to negotiate the terms and conditions of the agreement exactly as they would like. Theoretically, for a currency forward, two parties could agree to exchange any two currencies at any rate at any time in the future that they would like.
This is particularly important in FX hedging because it allows a business or individual who is exposed to risk from a potential change to the exchange rate to create the perfect hedge against this risk.
When it comes to companies that operate internationally, for example, it is usually possible to accurately quantify the amount of currency that a company needs to cover with a prearranged exchange rate. If a business were to hedge using a futures contract, they would be limited in terms of the amount that they could cover, the currencies they could cover, and the dates by which the contracted exchange would be completed.
With an over-the-counter forward trade, however, they would be able to cover the exact amount of the exact currencies they would like to with an ideally matching contract completion date.