Forward Market

Forward Market

Key takeaways
* A forward market is an over-the-counter (OTC) market where parties agree today on the price of an asset for delivery at a future date.
* Forward contracts are customizable (size, maturity) and commonly used for foreign exchange, commodities, interest rates, and securities.
* Forward pricing is driven by interest-rate differentials; in FX it reflects the interest-rate gap between two currencies.
* Common FX forward instruments include outright forwards and swaps; non-deliverable forwards (NDFs) provide cash-settlement for restricted currencies.

What is a forward market?
A forward market matches buyers and sellers who agree now on the terms—amount, price and settlement date—for delivery of an asset in the future. Unlike exchange-traded futures, forwards are traded OTC and tailored to the needs of the counterparties.

How forward contracts work
* Customization: Parties can set contract size, exact maturity dates and settlement terms to fit specific exposures.
* Counterparties: Transactions are typically between financial institutions (e.g., banks) or between a bank and a corporate or institutional client.
* Uses: Forwards are used to hedge future price or currency risk and to speculate on future price movements.

Pricing
Forward prices are determined by interest-rate relationships:
* In foreign exchange, the forward rate is derived from the spot rate adjusted for the interest-rate differential between the two currencies over the contract period.
* For interest-rate forwards, pricing is linked to the yield curve and expected rates to maturity.

(In practice, the forward FX rate can be viewed as the spot rate adjusted by forward points that reflect the interest-rate gap between the two currencies for the given term.)

Foreign exchange forwards
FX forwards are a major use of the forward market. Two common structures:
* Swaps: Interbank transactions often take the form of swaps—buying one currency vs. another on the spot date and reversing the trade at a predefined forward date. The forward leg is priced as the spot plus or minus forward points.
* Outright forwards: A straight purchase or sale of one currency for another on a future business day. No funds usually change hands until settlement, and the contract can specify any date and amount.

Market characteristics
* Liquidity: Most liquid for short to medium-term tenors (one week, one month, three and six months); liquidity typically declines beyond 12 months.
* Sizes: Interbank trades commonly involve large sums (tens of millions of dollars or more), while customer trades can be for any size.

Non-deliverable forwards (NDFs)
NDFs are used for currencies that cannot be freely traded or delivered onshore due to capital controls or regulatory restrictions. Key points:
* Executed offshore and always cash-settled, typically in a convertible currency such as USD or EUR.
* Settlement is the net difference between the agreed forward rate and the prevailing reference (spot) rate at maturity.
* Common NDF currencies include the Chinese renminbi (in earlier periods), Korean won, and Indian rupee (markets and availability can evolve).

Forward vs. futures: main differences
* Customization: Forwards are customizable; futures are standardized contracts traded on exchanges.
* Counterparty risk: Forwards carry bilateral counterparty risk; futures use exchange clearinghouses and margining to mitigate that risk.
* Settlement: Forwards typically settle at maturity (physical or cash); futures may be marked to market daily.

Uses and participants
Participants include banks, corporations, hedge funds and institutional investors. Typical motivations:
* Hedging currency or price exposure tied to future cash flows.
* Locking in financing costs or yields.
* Speculating on future movements in exchange rates, interest rates or commodity prices.

Conclusion
Forward markets provide flexible, OTC mechanisms to lock in future prices and manage risk across currencies, interest rates and commodities. Their customization and interest-rate–based pricing make them especially useful for tailored hedging needs, while specialized forms like NDFs allow access to restricted currency exposures.