What it means
A forward market is not a building or a screen; it is the network of banks, brokers and corporate counterparties that write forward contracts with each other. A forward contract is a private agreement to buy or sell an asset at an agreed price on an agreed future date, and nothing changes hands when the deal is struck.
The biggest forward market in the world is foreign exchange, where a bank will quote a company a rate for delivering euros, yen or pounds in one, three, six or twelve months. There are also busy forward markets in commodities such as crude oil, grain and industrial metals, and in interest rates through instruments called forward rate agreements.
The business reason for using one is certainty rather than profit. A manufacturer who knows in March that it must pay a supplier 5,000,000 euros in September can fix the exchange rate now and put a firm number in the budget, instead of hoping the rate drifts in its favour.
Forward markets differ from futures markets in three practical ways: forwards are tailored rather than standardised, they settle once at maturity rather than being marked to market every day, and they carry counterparty risk because no clearing house stands behind them. That last point matters, because a forward contract is only as good as the bank or trading partner on the other side of it.
Prices quoted in a forward market are not forecasts, which is the single most common misunderstanding. They are built from the spot price plus the net cost of holding the asset until delivery, so a forward price above spot usually reflects financing, storage or an interest rate gap rather than a view that prices will rise.
In practice
Real-world examples.
Example
A UK software firm bills a US client $2,400,000 payable in four months. Its treasurer sells the dollars forward to a bank at a fixed rate, so the sterling revenue booked in the forecast cannot be eroded if the dollar weakens before the invoice is paid.
Example
A regional bakery chain agrees a six-month forward purchase of 800 tonnes of milling wheat with a grain merchant at an agreed price per tonne. The chain gives up any benefit from a good harvest, but it can now sign a twelve-month supply contract with a supermarket at a fixed loaf price without fear of a margin squeeze.
Example
An airline expecting to take delivery of aircraft parts priced in euros in nine months uses the forward market to fix its euro cost. Its finance director notes that the forward rate is worse than spot, and explains to the board that the gap simply reflects the interest rate difference between the two currencies, not a market prediction.
Formula
Calculation
Forward price = spot price + cost of carry, where cost of carry is financing plus storage and insurance, less any income the asset produces while it is held.
A distributor needs 1,000 tonnes of copper alloy in six months. The spot price is $500 per tonne, six-month borrowing costs 4% a year, and storage plus insurance works out at $10 per tonne for the period.
Financing cost per tonne = $500 x 4% x 0.5 = $10.
Forward price per tonne = $500 + $10 + $10 = $520.
Total contract value = 1,000 x $520 = $520,000.
The distributor can therefore lock in $520,000 today for metal it will receive in six months, whatever the spot price does in the meantime.Case study
Seen in the real world.
The following illustrative example uses a fictional business. Harborline Instruments, an invented maker of laboratory equipment, sold most of its output into the euro area while paying its staff and suppliers in dollars. Every quarter the reported gross margin moved by several percentage points for reasons that had nothing to do with the factory, and the board grew tired of explaining currency noise to its lenders.
The finance team began selling 70% of forecast euro receipts forward on a rolling six-month basis, leaving the remaining 30% unhedged because sales forecasts that far out were unreliable. Over the next two years the forward contracts sometimes settled above and sometimes below the prevailing spot rate, and the net gain across the whole period was close to zero.
That was the point. Harborline had not tried to beat the market; it had bought predictability, and its quarterly margin now varied by less than one percentage point from currency movement. The lending bank cut the covenant headroom it demanded, which saved the fictional company more each year than any of the individual contracts had gained or lost.
Watch out
Common mistakes.
- Treating the forward price as the market's forecast of the future spot price, when it is really the spot price adjusted for interest, storage and financing costs.
- Assuming a forward contract can be walked away from if the spot price moves your way, when it is a binding obligation to deliver or take delivery.
- Ignoring counterparty risk because the contract is with a bank, and forgetting that a forward has no clearing house standing behind it.
Questions
People also ask.
Is a forward market the same as a futures market?
No, futures are standardised exchange-traded contracts settled daily, while forwards are private, tailored and settled once at maturity.
Do I pay anything when I enter a forward contract?
Usually nothing up front, although a bank may require collateral or a credit line to cover the exposure it is taking on you.
Can a forward contract be cancelled early?
It can be closed out by agreeing an offsetting contract or paying the bank the current market value of the position, but it cannot simply be torn up.
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