What is Forward Market and How Does it Work? A Complete Guide

A forward market is one of the oldest segments in the derivatives market. It enables buyers and sellers to enter into customised agreements for buying and selling an asset at a mutually agreed price on a future date.

A forward contract is a derivative instrument whose value is derived from an underlying asset or financial variable and which can be used to manage the price risk associated with foreign exchange, commodities and other financial assets. Exporters, importers, manufacturers, financial institutions and large corporations may use forward contracts to manage exposure to unfavourable price movements.

The regulatory framework applicable to forward contracts in India depends on the underlying asset, transaction and participating entities. Foreign exchange forward contracts involving persons resident in India are subject to the applicable RBI regulations and FEMA framework, while forward or derivative contracts in other markets may be subject to different regulatory frameworks.

This comprehensive guide discusses what forward market derivatives are, how they work, their types, benefits, risks and comparison with futures, swaps, and options.

What is a Forward Market?

A forward market is a marketplace where two parties enter into a privately negotiated deal to buy or sell an asset at a predetermined price on a future date. The agreed price and other terms and conditions of the deal are recorded in an agreement called a forward contract.

A forward contract is a customised agreement formed according to the needs of both parties. Unlike standardised exchange-traded futures, forward contracts are negotiated between participants. The purpose of these contracts may include managing the price-related risks faced by the companies.

A forward market operates in an OTC market. The participants can negotiate the contract size, settlement date, delivery terms, pricing and other conditions according to their contractual requirements. This flexibility allows forward contracts to be structured according to specific business requirements.

These contracts are commonly used by exporters, importers, manufacturers, commodity traders, and MNCs. They use forward contracts to manage exposure to prices and other variables and the financial risks arising from volatile market movements.

Also Read: What are Swap Derivatives?

How Does the Forward Market Work?

The working mechanism of the forward market follows a structured process despite operating in the OTC market. Here is the step-by-step guide to understand the working:

• Step 1: Identification of Need

The buyer and seller identify the need to manage exposure to future price fluctuations. They decide to enter into a forward contract.

• Step 2: Negotiate Contract Terms

Both parties negotiate the asset, quantity, delivery date, settlement method, price and other contractual terms according to their requirements.

• Step 3: Sign the Forward Contract in the OTC Market

After reaching the mutual agreement, both parties enter into the forward contract. The agreement creates contractual obligations between the parties, subject to its terms and applicable law.

• Step 4: Hold the Contract

The contract remains active until the agreed settlement date. During this period, market prices of the underlying asset may increase or decrease.

• Step 5: Settlement on Maturity

On the maturity date, settlement takes place according to the contract terms. The settlement may involve physical delivery or cash payment.

• Step 6: Complete the Transaction

Both parties fulfil their contractual obligations. The contract ends after successful settlement between the buyer and seller.

Types of Forward Contract in Derivatives

Forward contracts are classified into four commonly discussed types:

Flexible Forward Contract

A flexible forward contract allows the buyer or seller to settle the contract on any date within a predetermined period, rather than on a single fixed date, subject to the terms of the contract. This flexibility can help businesses manage uncertain payment schedules while managing exposure to adverse price movements. Flexible forwards are commonly used in foreign exchange risk management.

Closed Outright Forward Contract

A closed outright forward is a contract with a fixed settlement date that is generally fixed under the contract and may be changed only by mutual agreement between the parties. Both parties agree on the exchange rate or asset price before execution. This contract provides certainty and can suit businesses with fixed payment or delivery obligations.

Non-Deliverable Forward Contract

A non-deliverable forward is settled through a cash payment rather than physical delivery of the underlying currency. The difference between the agreed contract price and the applicable market reference rate or price at settlement is used to determine the settlement amount. Non-deliverable forwards are commonly used in currency markets where physical settlement of the relevant currency is restricted or impractical.

Long-Dated Forward Contract

A long-dated forward is a forward contract with a maturity that is generally longer than one year. Businesses may use these contracts for long-term projects and international trade commitments. Long-dated forwards can help manage future price uncertainty over extended business planning periods.

Practical Example of Forward Contract

An Indian automobile manufacturer imports steel from Japan and expects to make a payment of $2 million after six months. The company is concerned that the Indian rupee may weaken against the US dollar, making the import more expensive.

To manage this risk, the company enters into a forward contract with a bank in the OTC market. The contract specifies the exchange rate at ₹85 per USD for settlement after six months.

If the market exchange rate rises to ₹88 per USD after six months, the company can purchase the dollars at ₹85 per USD under the terms of the forward contract. This can protect the company from higher exchange-rate-related import costs and provide greater certainty for financial planning.

Difference Between Forward Market vs Futures Market

Here are key differences between the forward market and the futures market:

Comparison Between Forward Contract and Swaps

Both contracts are traded in the OTC market. Despite the many differences between forward contracts and swaps:

Forward Contract vs Options

Forward contracts and options are both derivative instruments, but they differ in their contractual obligations and market structures. Here are the other key differences:

Role of Forward Market in India

Here are some key roles of the forward market for businesses:

• Price Risk Management:

The forward market enables businesses to agree on future prices. This can reduce uncertainty associated with fluctuating commodity and currency markets.

• Support for International Trade:

Exporters and importers use forward contracts to manage foreign-exchange exposure associated with their transactions. They can manage the impact of unfavourable exchange rate movements on their revenues and payments.

• Business Planning:

Companies can estimate future costs more accurately. Greater price certainty under a forward contract can support budgeting, investment decisions, and long-term financial planning.

• Customised Hedging Solutions:

Businesses create contracts according to operational requirements. Customised agreements can help address specific exposure and settlement requirements across different industries.

• Market Stability:

The forward market can help businesses manage financial uncertainty. Risk-management activity can support more predictable commercial cash flows.

Benefits of Forward Market

Here are some common benefits of forward markets:

• Customised Contracts:

Forward contracts can be structured to match specific business requirements. Flexible contract terms allow participants to align the contract with their exposure and settlement requirements.

• Effective Risk Management:

Businesses can use forward contracts to manage exposure to future price fluctuations. A predetermined price can provide greater financial predictability for the contracted transaction.

• No Daily Settlement:

Unlike futures, forward contracts generally do not involve daily mark-to-market settlement through an exchange clearing mechanism. This means the timing of cash flows differs from that of exchange-traded futures.

• Supports Business Planning:

Fixed future prices under a forward contract can assist with budgeting decisions. Companies can use the agreed contractual price when preparing financial forecasts for the underlying transaction.

• Wide Commercial Applications:

Forward contracts are used in multiple industries including agriculture, manufacturing, exports, imports, commodities, and foreign exchange trading, subject to the applicable regulatory framework.

Risk Involved in Forward Market

Forward contracts involve risks that participants need to understand.

• Counterparty Risk:

One party may fail to fulfil contractual obligations. Default can create financial losses for the other party, depending on the contract and prevailing market conditions.

• Low Liquidity:

Forward contracts are privately negotiated. Exiting the agreement before maturity may become difficult under changing market conditions because there may be no readily available secondary market.

• Lack of Transparency:

Since many forward contracts are negotiated in the OTC market, price information may be less transparent than for exchange-traded futures contracts.

• Opportunity Loss:

Locked prices may become unfavourable if market prices move significantly in a direction that would otherwise have benefited the participant before contract maturity.

• Regulatory Limitations:

Different regulations apply across markets and asset classes. Participants are subject to the applicable legal and regulatory requirements for the relevant transaction.

Who Regulates the Forward Market in India?

The regulation of the forward market in India depends on the type of underlying and the nature of the transaction.

Foreign Exchange Forward Market

The Reserve Bank of India (RBI) regulates permitted foreign-exchange forward contracts under the applicable Foreign Exchange Management Act (FEMA) framework and RBI regulations. The RBI framework specifies requirements applicable to authorised dealers and eligible market participants for foreign-exchange forwards.

Commodity and Securities Derivatives

Exchange-traded commodity and securities derivatives, including futures and options, are regulated by the Securities and Exchange Board of India (SEBI) under the applicable securities laws and regulations. SEBI commenced regulating the commodity derivatives market in September 2015 following the repeal of the Forward Contracts (Regulation) Act, 1952 and the transfer of the regulatory framework to SEBI.

OTC Forward Contracts

Privately negotiated forward contracts executed in the OTC market are governed by the regulatory framework applicable to the underlying asset, transaction and participating entities, along with the contractual and other applicable legal requirements.

Factors to Consider While Participating in Forward Market

Here are some important factors associated with participating in the forward market:

• Counterparty Credibility:

The financial strength and ability of the counterparty to fulfil its contractual obligations are relevant considerations when assessing counterparty risk.

• Contract Terms:

Review pricing, settlement method, maturity date, and delivery conditions carefully. Clearly defined contractual terms can reduce ambiguity regarding the rights and obligations of the parties.

• Market Volatility:

Changes in the price or exchange rate of the underlying can affect the value and economic outcome of a forward contract before and at settlement.

• Liquidity Needs:

Evaluate future cash flow requirements carefully. Limited liquidity before maturity may affect the ability to exit or replace the contract before its scheduled settlement date. Legal

• Compliance:

Ensure the forward contract complies with applicable regulations. The relevant parties must comply with the regulatory, documentation and reporting requirements applicable to the transaction.

Who Can Participate in the Forward Market?

Retail traders generally do not directly participate in OTC forward contracts, which are commonly used by businesses and financial institutions. Participation depends on the type of forward contract, the applicable regulatory framework and eligibility requirements. Here are some participants commonly involved in forward market transactions:

• Exporters:

Exporters use forward contracts to manage exposure to exchange-rate movements affecting future export earnings from currency market volatility.

• Importers:

Importers may use forward contracts to manage exposure associated with future foreign currency payments. An agreed exchange rate can provide greater certainty regarding the contracted foreign-currency cost.

• Manufacturers:

Manufacturers may use forward contracts to manage exposure to raw material prices and other relevant costs.

• Commodity Traders:

Commodity traders may use forward contracts to manage future commodity prices, subject to the applicable regulatory framework.

• Banks:

Banks may offer permitted forward contracts to eligible customers. They also manage their own foreign exchange exposures through risk-management activities.

• Financial Institutions:

Financial institutions may use forward contracts and other derivatives for portfolio risk management and other financial purposes, subject to applicable regulations.

• Multinational Companies:

Global companies may use forward contracts to manage currency and commodity exposures arising from international operations and cross-border transactions.

FAQs

What is a forward market?

A forward market is a financial market where two parties enter into a customised forward contract to buy or sell an asset at a predetermined price on a future date. These contracts are privately negotiated and are generally traded in the OTC market rather than on recognised stock exchanges.

What is the difference between a forward contract and a futures contract?

A forward contract is a customised agreement generally traded in the OTC market, while futures contracts are standardised and traded on recognised exchanges. Forward contracts offer greater flexibility, whereas futures generally offer greater liquidity and price transparency, with central clearing reducing counterparty risk.

Who uses the forward market in India?

The forward market is commonly used by exporters, importers, manufacturers, commodity traders, banks, financial institutions, and multinational companies. These participants may use forward contracts to manage exposure to future price fluctuations in currencies, commodities, and other financial assets, subject to the applicable regulatory framework.

Is the forward market regulated in India?

Yes. The applicable regulator depends on the type of forward contract and underlying asset. RBI regulates permitted foreign-exchange forward contracts under the applicable FEMA and RBI framework, while SEBI regulates exchange-traded securities and commodity derivatives within its statutory jurisdiction.