Usually, when we discuss the forward market, we are talking about foreign currencies, although there are many other types of forward markets. For example, when one buys Japanese yen forward, one is fixing the exchange rate at which one will buy yen in the future, say in three months time. This rate is often called the 90 day forward rate on yen. If one wanted to buy yen today, then one would buy at the spot yen rate.
It may seem that the forward market is very much the same as the futures market. But, there are still some important differences. First, there are no standardized contracts in the forward market, which means that the amount transacted can be anything. Second, there is no organized exchange as there is in the futures market. Instead, transactions are handled over the counter between contracting parties. Third, unlike the futures market, the forward market does not have daily settlement. Profit or loss is determined at the expiration of the forward contract. Finally, the futures market has a clearinghouse, which accepts the risk of non-payment by participants. The forward market does not have such a clearinghouse, and each party must accept the risk of non-payment by the other contracting party. Beyond this, there are differences in commissions and margins which must be paid.
The forward market can be used to hedge currency exchange risks. For example, suppose that EVA, an international airline in Taiwan, decides to purchase three 747-40 jets from Boeing. The total cost will be $180 million USD, and payment will be made in 270 days. EVA is worried that the NT$ may depreciate during this time. The current spot rate is $27.5 NT/1US$, and at this rate, the cost would be $4.95 billion NT. If the NT$ depreciates 1.82%, the cost to EVA would rise to $5.04 billion NT, for an exchange loss of about $90 million NT. EVA could hedge this risk by purchasing $180 million USD 270 days forward. Suppose that the forward rate is $27.8 NT/1US$, which means that the cost of the jets to EVA would be roughly $5 billion NT. By doing this EVA eliminates the risk that the NT$ will greatly depreciate. This hedging policy merely fixes the rate which EVA must use, 270 days later, to convert its NT$ to US$. There is no guarantee that this forward rate will be the same as the spot rate 270 days later. The actual spot rate may be either higher or lower.
EVA could hedge the same transaction using a variety of other means (if they are available), such as currency futures, currency options, or even through a money market hedge.
14 September 2011
Market where dealers agree to deliver currency, commodities, or financial instruments at a fixed price at a specified future date. Most forward contracts are made for delivery at specific future dates, for example, one week from the transaction date, one month, and so on. Longer term contracts are more speculative in nature, and are substantially more risky.
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