Everything You Need to Know About Forward Market
Trading and investing are two financial practises that have been gaining importance globally. These are considered some of the best ways to grow your wealth. However, there are different methods to trade and earn profits.
The forward market is one such option. If you want to start trading in the forward market, educate yourself on the basics. And here is how you can start!
What is the Forward Market?
Before we know the forward market meaning, let us understand the derivative market.
A derivative market is a financial market that engages in financial instruments or derivative contracts such as forwards, futures, options, and swaps. Hedgers, arbitrageurs, speculators, and margin traders participate in the derivative market.
The contracts in the derivatives market are based on an underlying asset. The underlying asset can be equities, currencies, commodities, interest rates, etc. Commodities traded include oil, natural gas, grains, etc. When you engage in a derivative contract, you will transfer the risk associated with the underlying asset to another party willing to afford it.
Derivative contracts are traded on the stock exchange or Over the Counter (OTC). While SEBI regulates the trade on the stock exchange, the Over the Counter is completely based on an unorganised market that is dealer-oriented and happens through emails or phone calls without any defined rules.
The forward market is based on an Over-the-Counter contract wherein two parties agree to buy or sell a particular underlying asset at a decided price in the future. Forward contracts are customisable for the commodity, order size, and delivery date.
Important Terms in Forward Market
Here are a few important terms in the forward market:
- Underlying asset - It is the basic commodity, stock or currency that forms the basis of the contract.
- Quantity - It defines the size of the contract based on the underlying asset bought and sold.
- Price - Price of the quantity of the underlying asset to be executed in the contract.
- Expiration Date - The date when the contract is settled based on the agreement where one party delivers the asset, and the other makes the payment.
How is Forward Market Different from Other Contracts?
In a forward market, the participants are obliged to fulfil the contract. However, in the futures and the options market, the participants can sell the contract before the expiration date and close their position. Future contracts are standardised in order sizes, delivery dates, etc., and regulated by SEBI. Parties have to pay a margin for engaging in the futures contract.
Forward Market Example
Let us understand the functioning of the forward market with an example. The introduction of the forward market was primarily to safeguard farmers' interests from fluctuating price movements. However, it is still utilised for certain industries such as banks.
Consider a farmer who wants to sell his harvest, around 55 tons of rice in the next six months. Let us assume he wants to sell it at ₹60,000 per ton to earn a profit. He can either work on the harvest, wait for the price to increase, stabilise as per his expectations, and sell it out. But, on the other hand, he can enter into a forward contract with a retail outlet to sell the rice at the same price on a future date after the harvest.
The expectation of the farmer - The farmer safeguards his financial position to avoid a risk of a fall in prices to ensure the gain.
The expectation of the retail outlet owner - The retail outlet owner safeguards his financial price to avoid the risk of paying more for the rice if the price increases in the next six months.
So, the farmer will make profits if the price gets lower, and the retail owner will be at an advantage when the price of rice gets higher.
Forward Market Risks
Every trading platform has its associated risks that are highly probable to cause extensive losses for the parties in agreement.
- Regulatory risk - As the forward market is not regulated, no authority governs the agreement. Therefore, mutual consent is susceptible to becoming a failure. Furthermore, it can urge the parties to default the contract easily.
- Default risk - The parties can step away from the contract by either not paying for the asset or not delivering it during the settlement considering the prevailing price of the asset.
- Liquidity risk - Parties might opt to trade out as the extent of liquidity is low in the forward markets.
Forward markets play a significant role in safeguarding the interests and providing the necessary price support to the most important sectors in the Indian Economy. The forward contracts are very simple forms of the derivative market that are easy to understand and execute with good knowledge. And with experience, you can become smart traders by investing in the forward markets as hedgers or speculators!
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Frequently Asked Questions
Forward contracts do not mandate the participants to pay a margin amount before entering the contract, unlike in the futures market.
The buyer or the seller can cancel the forward contract upon a mutual agreement.
The spot market is based on the spot price of the asset that is available for buying or selling immediately. On the other hand, the forward contract is based on the purchase or sales of the underlying asset on a future date at a predetermined price.
As the price, quantity and expiration date are fixed during the start of the contract, it helps participants to hedge against the fluctuating price movements.