Forward Market

Not a formal market like the futures exchange, the “forward market” describes the informal over-the-counter trade of forward contracts. Forward contracts are similar to, and sometimes described as a type of, futures. Futures are different principally in their standardization and margining, giving them less of a credit risk; forwards, traded over-the-counter, are customized between parties.

A forward contract is an agreement to exchange an asset at a specific point in the future, with the payment exchanged in advance. That payment is called the forward price or forward rate; there are formulas that can be used to determine, based on the spot price of the asset, a forward price which entails no loss for either party. The lower limit of the price is the spot price modified by the risk-free rate of return over the period; the seller has no motive to delay selling if the price doesn't exceed what he could make by selling today and putting banking the payment. The seller, then, is at least guaranteed to be no worse off than if he or she were to sell today instead of on the forward market, and if the cost of the asset goes down or increases by less than the risk-free rate, then he or she is benefited further. The [Page 706]buyer takes the risk that the asset will increase in value at a rate equal to or greater than the risk-free rate.

These assets can vary considerably, and can include stocks, bonds, other securities, foreign currencies, and so on. They are principally used by speculators and hedge funds, and so are slightly more common in the foreign exchange market, especially with respect to “minor” currencies that are more subject to fluctuations—and therefore ripe for speculation—than stable, well-established currencies from major economies. Of course, because of the potential of reward beyond the risk-free rate, the forward market offers an opportunity for arbitrage.