This is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. The forward market is used for trading a wide range of instruments, but the term itself is mostly used with reference to the foreign exchange market. It can also apply to markets for securities and interest rates as well as commodities.
As forward contracts are almost the same as future contracts, there are some notable differences between the two. Forward contracts can be made to fit a customer’s needs, while future contracts have a more standardised feature in terms of the contract size and maturity. Forwards are executed between banks or between a bank and a customer, futures are done on an exchange which is a party to the transaction. The flexibility of forwards is a big reason as to why people find them so attractive in the foreign exchange market.
Pricing in the forward market is of course interest- rate based. The forward price is put together based on the interest rate differential between two currencies, which is applied over the period from the transaction date to the settlement date of the contract. In interest rate forwards, the price is based on the yield curve to maturity.
Interbank forward foreign exchange markets are priced and processed as swaps. This means that currency A is bought vs. currency B for delivery on the spot date at the spot rate in the market at the time the transaction is executed. When matured, currency A is sold vs. currency B at the original spot rate plus or minus the forward points (this price is set when the swap is put into play). The interbank market usually trades for straight dates like a week or a month from the spot date. Three-month and six-month maturities are some of the most common ones, while the market is less liquid beyond 12 months. Amounts are usually around $25 million and more and can range into the billions.
Corporations and financial institutions like hedge funds or mutual funds can execute forwards with a bank counterparty either as a swap or an outright transaction. In an outright forward, currency A is bought vs. currency B for delivery on the maturity date. This can be any business day beyond the spot date. The price is again the spot rate plus or minus the forward points, but no money will change hands until the maturity date. Outright forwards are often for odd dates and amounts; they can literally be for any size.
The most commonly traded currencies in the forward market are the same as on the spot market: EUR/USD, USD/JPY, and GBP/USD.
There are in fact three ways for corporations, institutions, and individuals to trade forex:
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