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2. Derivative markets: forwards

2.1. Learning outcomes

After studying this text the learner should / should be able to:

1. Describe the characteristics of forward markets.

2. Explain the essence and mechanics of forward contracts / instruments.

3. Understand the mathematics of the forward markets.

4. Calculate a forward price.

5. Distinguish the advantages and disadvantages of forward markets vis-à-vis futures markets.

6. Portray the organisational structure of the forward markets.

2.2. Introduction

Forward markets / instruments are the forerunners of the futures markets / instruments. However, not all forwards transmuted into futures markets. The forward foreign exchange market, for example, is a gargantuan market in terms of turnover and liquidity. There are also a number of other formidable forward markets such as forward markets in interest rate products (e.g. forward rate contracts). This significant derivative market is covered under the following headings:

• Spot market.

• Introduction to forward markets.

• A simple example.

• Forward markets.

• Forwards in the debt markets.

• Forwards in the foreign exchange market.

• Forwards in the commodities markets.

• Forwards on derivatives.

• Organisation of forward markets.

2.3. Spot market: definition

As we saw earlier, the spot market is also called the "cash market", and it refers to transactions or deals (which are contracts) that are settled at the earliest opportunity possible. For example (see Figure 1), in the money market a spot deal is where securities are exchanged for payment (also called delivery versus payment) on the day the deal is struck / transacted (T+0) or the following day. In many bond markets a spot deal is a deal done now (day T+0) for settlement in 3 days' time (T+3). In most share / equity markets spot means T+5. In the money market, deals are usually settled on the day of the transaction (T+0) or the following day (T+1).

spot & forward settlement (derivative markets)

Figure 1: spot & forward settlement (derivative markets)

The issue that determines the number after the "+" sign is essentially convenience. In the money market it is convenient to settle now or tomorrow, because the market is of a wholesale nature and the securities are kept in safe custody by banks in large metropolitan areas (or in a securities depository or are dematerialised). In the share market many individuals are involved that are spread across the county and, therefore, it takes time for the securities to be posted / sent to the exchange. This of course changes with dematerialisation / immobilisation7.

A spot deal may thus be defined as a contract between buyer and seller, undertaken on T+0, for the delivery of a security by the seller to the buyer and payment by the buyer to the seller in order to complete settlement of the deal at time T+0 or T+ a few days, depending on convenience / convention.

2.4. Forward market: definition

Like a spot deal, a forward deal is a deal done now (T+0) at a price agreed now. However (and this is the difference), the settlement date is not a few days after T+0 as in the case of spot transactions, but usually a month or a few months after T+0 (see Figure 2.1). The motivation for such a deal is usually that the spot price that will prevail in the future is uncertain. A forward deal removes the spot price uncertainty.

The best way to describe a forward deal is with an example. Consider a wheat farmer. He plants his crop now and expects to reap the harvest in 3 months' time. He knows the input cost, but he does not know what spot price he will get for his harvested wheat in 3 months' time. Thus, he is faced with (spot) price risk (uncertainty). The solution to his risk is a forward (or futures) market that will enable him to sell his wheat forward, in other words he would like to deal now (T+0) at a price agreed now (T+0) for delivery of the wheatin3 months time(T+3 months) when lie will be paid.

spot deal on T+0 on 3-month asset

Figure 2: spot deal on T+0 on 3-month asset

A forward deal in the financial markets is the same except that the instrument dealt in:

• has a term to maturity and

• may have an income (dividend on a share / interest on a bond).

forward deal on 3-month asset (settlement in T+3 months)

Figure 3: forward deal on 3-month asset (settlement in T+3 months)

A spot deal on a 3-month financial asset is portrayed as in Figure 3. A forward deal is where the price or rate on an asset is determined now for settlement at some stage in the future. Some stage means other that spot. A 3-month forward deal on a 3-month asset is shown in Figure 3.

Thus a forward is a contract between a buyer and a seller that obliges the seller to deliver, and the buyer to accept delivery of, an agreed quantity and quality of an asset at a specified price (now) on a stipulated date in the future. A simple example will clarify this definition further see Figure 4).

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