What Is a Forward Market?
A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, but the term is primarily used with reference to the foreign exchange market. It can also apply to markets for securities and interest rates as well as commodities.
Key Takeaways
- Forward contracts differ from future contracts in that they are customizable in terms of 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.
How A Forward Market Works
A forward market leads to the creation of forward contracts. While forward contracts—like futures contracts—may be used for both hedging and speculation, there are some notable differences between the two. Forward contracts can be customized to fit a customer’s requirements, while futures contracts have standardized features in terms of their contract size and maturity.
Forwards are executed between banks or between a bank and a customer; futures are done on an exchange, which is a party to the transaction. The flexibility of forwards contributes to their attractiveness in the foreign exchange market.
Pricing
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, which is applied over the period from the transaction date to the settlement date of the contract. In interest rate forwards, the price is based on the yield curve to maturity.
Foreign Exchange Forwards
Interbank forward foreign exchange markets are priced and executed as swaps. This means that currency A is purchased vs. currency B for delivery on the spot date at the spot rate in the market at the time the transaction is executed. At maturity, currency A is sold vs. currency B at the original spot rate plus or minus the forward points; this price is set when the swap is initiated.
The interbank market usually trades for straight dates, such as a week or a month from the spot date. Three- and six-month maturities are among the most common, while the market is less liquid beyond 12 months. Amounts are commonly $25 million or more and can range into the billions.
Customers, both corporations and financial institutions such as hedge funds and mutual funds, can execute forwards with a bank counter-party either as a swap or an outright transaction. In an outright forward, currency A is bought vs. currency B for delivery on the maturity date, which can be any business day beyond the spot date. The price is again the spot rate plus or minus the forward points, but no money changes hands until the maturity date. Outright forwards are often for odd dates and amounts; they can be for any size.
Non-Deliverable Forwards
Currencies for which there is no standard forward market can be traded via a non-deliverable forward. These are executed off-shore to avoid trading restrictions, are only executed as swaps and are cash-settled in dollars or euros. The most commonly traded currencies are the Chinese remnimbi, South Korean won, and Indian rupee.
