Understanding the Forward Market

The forward market functions as an off-exchange platform where the future price of a financial instrument or asset is established for delivery at a later date. Although forward markets cater to a variety of instruments, they are primarily associated with the foreign exchange market. However, they can also cover securities, interest rates, and commodities.

Key Points to Note

• Forward contracts, as opposed to futures contracts, offer customization in terms of size and maturity period.
• Pricing of forward contracts is influenced by interest rate differentials.
• Commonly traded currencies in the forward market include EUR/USD, USD/JPY, and GBP/USD.

Operational Mechanisms of the Forward Market

The forward market operates through the creation of forward contracts, distinct from futures contracts. While both are used for hedging and speculation, forward contracts are tailored to meet specific customer requirements, unlike standardized futures contracts.

Forwards are typically executed between banks or between a bank and a customer, whereas futures transactions occur on a designated exchange. The flexibility of forward contracts makes them appealing in the realm of foreign exchange.

Pricing Dynamics

Pricing in the forward market is largely interest-rate-oriented. In the foreign exchange realm, forward prices are determined by interest rate differentials between currencies, applied from the transaction date to the contract settlement. Interest rate forward pricing is rooted in yield curve considerations.

Foreign Exchange Forward Contracts

Interbank forward foreign exchange markets function via swaps, where currency A is bought versus currency B at the current market spot rate for delivery on the spot date. At maturity, the currencies are swapped back at the original spot rate plus or minus forward points, pre-determined at the swap’s initiation.

In the interbank market, trading typically spans shorter durations, like one to six months, with volumes often exceeding millions and sometimes billions. Corporations, hedge funds, and mutual funds engage in forward transactions with banks, either as swaps or outright deals.

Outright forward transactions involve buying currency A against currency B for delivery on the maturity date, beyond the spot date. Money is exchanged at maturity based on the spot rate and forward points, with flexibility in transaction size and date.

Non-Deliverable Forwards

Non-deliverable forwards cater to currencies without a standard forward market. These swaps are settled in dollars or euros and are off-shore to sidestep trading regulations. Popular currencies traded in this segment include the Chinese renminbi, South Korean won, and Indian rupee.