The forward exchange market is one where dealers can form forward contracts to ensure the delivery of goods in the future at a specified exchange rate. Current commitments are fulfilled at a later date in the forward exchange market.
The price of the forward contracts that are formed in the market is called forward exchange rate. They are not entirely disconnected from the normal foreign exchange market or the exchange rate, but provide a means of trade that wouldn’t exist in the normal markets. Let’s find out more about forward exchange market.
How Does The Forward Exchange Market Work?
The forward exchange market works by the creation of forward exchange contracts. Both parties use the forward exchange contract to lock in an exchange rate on a specific date for an exchange of goods. The forward exchange markets can be used for a range of goods but are primarily used for the trade of currencies.
A good forward market example is the best way to understand the concept. Let us take a farmer who is selling his harvest, say apples, in three months’ times. The market price of his apples can either be high or extremely low. The market is unpredictable and, therefore, cannot be relied upon to provide a guaranteed profit.
On the other hand, we have a restaurant. The restaurant purchasing apples is also going to be affected by the unpredictable prices of apples. So, for their mutual benefit, the farmer and the restaurant engage in a forward contract. The terms stipulate that in three months’ time, the farmer will receive a certain price for his apples regardless of the market price at that moment. The market for these transactions is known as the forward market.
In the actual forward exchange market, the ones that actually deal are only ‘authorized’ dealers. These are usually institutions such as banks that have large financial reserves and resources. An individual or business trade through these ‘authorized’ dealers. These institutions, usually a bank, will either be dealing directly with another ‘authorized’ dealer or directly with the other party.
What are the different types of dealings?
Forward exchange markets are primarily used for three types of dealings:
Interest arbitrage
Interest rate arbitrage involves using favorable interest rates differentials to turn a profit. An investor will shift their funds and assets from one country to another because of the higher interest rates.
To do so, they require the proper currency which they sell once they want to repatriate their money. This requires an assurance that the exchange rate will remain stable or be profitable. Forward contracts provide assurance of a stable exchange rate.
Speculation
Speculation in finance involves conducting a trade that has a high risk or reward potential. The trade can go either way, depending on the price movements and other factors. Such trades are meant to capitalize on market fluctuations.
When it comes to the forward exchange market, this means that speculators will buy currencies and hold onto it so that when the contract is over, the money they receive can be used to purchase more.
For example, a speculator buys currency A (sells currency B) in the forward market, at the same rates as those in the spot market. In that case, chances are in three months, if currency B has been devalued, then he can buy a larger quantity of currency B.
Speculative investments do not always go smoothly, but if done right, can yield high rewards.
Commercial purposes
When there are traders conducting business in different countries, forward markets can prove to be very profitable. For example, an importer from country A has to make payment in country B, and they buy units of currency B in the spot market.
After purchasing the units, the value in the forward market dips rapidly, turning a profit for the importer. This profit is only possible for those who cover in the forward exchange market sometimes. There are two other types of traders in the market: (1) those who never cover in the forward market; (2) those who always cover in the forward market.
Features of the Forward Exchange Market
There are some key features that better outline the way the forward exchange market operates.
Direct Dealing
The forward exchange market has all the participants actively discussing the deal. The market participants are directly negotiating and creating contracts with brokers-dealers. All contract terms are formed and negotiated by the private parties; the major banks serve as a means through which to trade.
Delivery Based Transactions
As mentioned in the example, the goods that are being negotiated are generally delivered in the future. Whether it is physical commodities or securities, all the transactions are happening sometime in the future, so all transactions are based on the goods being delivered.
Customizable Contracts
Unlike futures contracts, forward exchange contracts are customizable to the participants’ requirements. The quantity, delivery dates, and prices are all customized as per the terms negotiated between the parties.
Unregulated
The contracts and the market itself is generally unregulated. The government does not usually intervene in its working unless there is specific action needed.
Importance Of The Forward Exchange Market
International trade generally comprises of imports and exports. The importing and exporting of goods takes time. They involve a waiting period in which a lot can change. Exchange rates and market prices for goods do not stay stable for long.
The unpredictability of exchange rates means there is an exchange risk involved. A change in the exchange rates between the time of sale or purchase and delivery can lead to losses on one side. A forward contract will offset the risk that comes with ‘spot transactions.’
The forward exchange market allows for an individual or a corporation to work without any uncertainties about the future. The customization options of forward contracts are sometimes preferable for those who don’t want to deal with the rigidity of standardization in the future market.
Benefits Of The Forward Exchange Market
With every market comes its own set of advantages and disadvantages. The forward exchange market is no different. Given below are some of the benefits and limitations of the same:
Complete Hedge
The pricing of some commodities is likely to be unpredictable. In these situations, parties will need to find a way to reduce the risks that come with the uncertainty of the market.
A forward contract created in a forward exchange market provides a complete hedge to such risks. When the seller and buyer enter a contract and lock on an exchange rate, they’re assured of payment rates and avoid uncertainties regarding the same.
Customization
Forward contracts offer the flexibility that a future contract cannot. The parties involved decide their own terms and conditions. The quantity, price, delivery date, and other specifications are all decided by those involved. This customization option adds to the convenience of both parties.
No Upfront Costs
The forward contract does not require any costs to be paid upfront. Rather, the whole amount is paid at a set decided future date as per the decided exchange rate.
Limitations Of The Forward Exchange Market
Unregulated
The forward exchange market is unregulated. The lack of regulation is an advantage for the most part, but occasionally it can pose problems. The fact that it is unregulated means that the contracts aren’t strictly adhered to. It can be difficult to cancel a contract, and often one party might default. This means that there is a significant risk that a counterparty will fail to deliver.
Opportunity Cost
When fixing the exchange rate at a certain point, the risk of making a loss is certainly taken away. However, in the process, an extra profit that might’ve been made is also lost. When such an exchange is agreed to, the benefit from the movement of exchange rates is lost.
FAQ
What is the forward exchange rate?
The forward exchange rate is what determines the prices in the forward exchange market. The rates are generally based upon interest rates and can be used to speculate on future spot exchange rates.
What is a futures market?
A futures market is where participants future contracts for the delivery of goods on a certain future date.
What is the difference between forward contracts and futures contracts?
Forwards are more customizable contracts that deal with more physical deliveries. Futures contracts are generally standardized and done with products on exchanges.
Endnotes
The forward exchange market is a significant part of normal international trade. The market has and can influence trade policy significantly. It also serves as a way for speculators to judge the valuation of currency on the spot market.
The market provides a benefit for both parties and customization options that can suit the needs of both. The customizable options, along with the completely hedging, make the forward exchange market an attractive option for many investors.