In the economy, there are a huge number of financial instruments. Let's talk about one of them. A forward contract is, in fact, a contract concluded between two parties that describes in detail the purchase or sale of a specific amount of the underlying asset at a clearly defined cost, with the terms of the agreement in the future inclusive. Signing this type of contract means that one of the parties to the transaction - the seller, undertakes to deliver a specific amount of underlying assets to the number specified in the contract, but which is remote with respect to the date of signing the contract. The other side - the buyer, assumes the obligation to accept delivery on time.
Key Features of Contracts
The date the forward contract is signed is called the date of agreement. The number determined by the parties as the time of the agreement is called the date of payment or settlement. The time interval from the moment of signing the contract to the time of settlement is called forward. Contracts can be concluded for any terms and amounts of funds, it all depends solely on the needs of each of the parties. Forward transactions are considered to be the most effective, the value of which begins with $ 5 million. Within the framework of the international derivatives market, the amount of contracts varies from 1 to 100 million. Each of the parameters - the date of signing the contract and the settlement date, the transaction amount and the volume of the underlying asset - are determined purely in an individual mode. There are no restrictions on this issue.
Risk hedging
Thanks to the preliminary determination of the value of the contract, it is possible to hedge risks. By setting the value of a financial instrument, both the seller and the buyer are completely freed for the forward period from the risk of changes in market value. The transaction does not allow the acquisition of certain benefits. The seller does not receive a material advantage in case of an increase in the value of an asset in the market, and the seller does not receive a result of a fall in the same asset. If this situation occurs, then one of the parties may refuse its obligations, as it gets the opportunity to make a deal on more favorable terms. Contracts are defined as solid forward transactions. It is the obligation to fulfill its part of the agreement that underlies them; without this feature, the instrument would cease to exist as a direction for hedging risks.
Story
Forward transactions first appeared about 400 years ago. They had the format of arrangements for the sale of future crops. Over the past few decades, contracts have become particularly popular, with financial instruments being the main subject. The forward financial market is essentially an OTC market. Exchange trading is unacceptable because of the individuality of the conditions for concluding agreements. Formally, any business entity can participate in contract trading. In practice, the choice of a partner is carried out very carefully and carefully, as it reduces the risk of delivery disruption.
Forward Market Participants
For the most part, the parties to the agreements are large banks and pension funds, insurance companies that have a positive reputation. Certain categories of transactions are subject to certain restrictions.As an example, forward loan transactions, in which one party must have an open credit line in the company that acts as the second party in the agreement. Private entrepreneurs can also act as bidders, but they must have a powerful material base and be active participants in world financial life.
Who determines the mood in the forward market?
The most active players in the forward market are banks. They actively use a forward currency purchase contract to hedge their own risks associated with changes in the value of financial instruments. Financial institutions offer this type of arrangement with a similar purpose to their clients. Due to the wide financial possibilities in terms of distribution and attraction of material resources, banks, unlike other bidders, avoid real losses even if market prices do not play into the hands. By concluding two opposite contracts, the bank manages to easily cover the loss on one transaction with profit on the other. Banks can also act as intermediaries, which help to find market participants with opposing desires.
Contract Trading Specifics
Forward contract trading does not have a clear organized structure. The low competition in this segment of activity gives banks certain advantages in the form of the opportunity to impose their terms of partnership on the parties to the agreements. The profit that forward foreign exchange contracts can bring is largely dependent on the ability to predict the future value of the asset, which is the basis of the agreement.
Banks win here because they have access to a huge amount of information, professional analysts work in them. This leads to the formation of a huge and active supply market, the OTC stock market. Forward contracts can be signed not only for the real amount of funds, but also for a conditional one. In the latter situation, after the implementation of the agreement, in the event of a difference in the contract and market value of the underlying asset, one of the parties pays the other only the price difference. Actual exchange of currencies, stocks, securities and other financial instruments does not occur.
Advantages of contracts
A forward contract is a universal financial instrument that has certain advantages over others like it. The main advantage of the transaction lies in its individual nature, which allows a very professional hedging of risks. Forward agreements do not provide for the seizure of additional funds, commissions. As for privileges for banks, it is possible to note the ability to establish the value of the underlying asset and dictate its terms of the agreement, since the transactions are over-the-counter.
Cons of contracts
The main disadvantage of the contract is the lack of room for maneuver. The obligation of the parties to fulfill their part of the agreement does not allow to terminate the contract or modify its terms before the deadline. The absence of a secondary forward market makes resale of the contract simply impossible. This leads to a sufficiently low liquidity of the instrument with a too high risk of non-fulfillment by one of the parties of its obligations. The tight trading framework forced market participants to look for loopholes. For example, today the practice of concluding contracts is very common, which provides for the possibility of termination of agreements by agreement of two parties or on the initiative of one, but with subsequent payment of compensation.
What limits the number of participants in the forward market?
The number of participants in the forward market is strictly limited by a whole set of norms and standards.In order to purchase or sell a forward contract, trading participants must have a credit line, a high rating and stable financial contacts with a banking institution. The lack of forward transactions for participants is due to limited opportunities when choosing a partner bank; you have to accept the conditions dictated by financial institutions upon. Certain difficulties are associated with the search for partners, because finding a party that is ready to take the opposite position is not so easy. This leads to insufficient popularity and activity of the forward contract market.
What is the difference between futures and forward contracts
Future value contracts are forward and futures. The difference between them is significant. The forward is signed between the buyer and seller, while the main objective of the partnership is the real supply of the asset. Forward arrangements are realized within the OTC market, which leads to low liquidity of the instrument in comparison with futures. For example, it is very difficult to find a buyer for hundreds of tons of metal if it is no longer relevant for a particular plant.
Futures in comparison with the forward acts as a standardized contract, the main purpose of which is this is speculation. There is no question of any real supply. Forwards and futures, despite the apparent apparent similarities, are used for opposing purposes. The term “standardized” means a clear limitation of the quantity of goods by the terms of the exchange. Only whole lots are allowed to trade. For example, a lot of copper is 2500 pounds, and wheat is 136 tons. Options, forwards and futures are financial instruments, but the purpose of their existence is different, which determines the specifics of the application.
Forward foreign exchange contracts
The general characteristic of a currency-type forward contract provides for a preliminary clarification of the partnership conditions in the following parameters:
- The currency of the contract.
- The amount of the transaction.
- Exchange rate.
- Payment date.
The duration of forward transactions can vary from 3 days to 5 years. The most common contract terms are 1, 3, 6, and 12 months from the date of conclusion of the contract. A forward foreign exchange contract is inherently categorized as banking operations. It is not standardized and can be adapted to any situation. The forward transactions market, the duration of which does not exceed 6 months in dominant currency pairs, is very stable. The market segment within which transactions are concluded for 6 months or more is unstable. Any realized long-term transaction may cause a significant fluctuation in exchange rates for foreign exchange market.
Types of Forward Operations
The forward contract can be presented in two formats:
- A simple forward transaction, or an outright agreement. This is a single conversion transaction that has a clear value date that differs from the spot date. The situation does not provide for a simultaneous reverse transaction. An agreement is concluded between the parties on the provision of a certain amount for a clearly defined term and at a fixed rate. This format of operations is widely used for insurance against exchange rate volatility.
- Swap deals. This tandem is the opposite of conversion type transactions that have different value dates. Currency transactions between banks are a kind of combination between buying and selling one currency, but at completely different time intervals. A certain amount in the equivalent of one currency is simultaneously sold and bought on the market for a clearly defined period and vice versa.
Considering the question of what a forward contract is, it is worth clarifying the fact that these types of agreements use a specialized forward rate, which is radically different from the spot rate.The reason lies in the differences between the interest rates on deposits that countries offer. For the calculation of the forward rate, a specialized formula is used.
