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2.10. Forwards in the commodities market

Above we have discussed the forward markets in the debt market and the foreign exchange market. There are also forward markets in many commodities, but they will not be discussed here, because the principle remains the same. Only the math is slightly different because other costs, such as storage (which usually includes insurance), is taken into account:


FP = forward price

SP = spot price

ir = interest rate for period, i.e. period from now to the forward deal date

dte = days to expiry (of forward contract, i.e. until forward deal date)

t = dte / 365

SC = storage costs.

It will be evident that this is a "carry cost" (CC) model, where there are two costs, interest and storage, and no income on the asset is forthcoming (if income were forthcoming the model becomes a "net carry cost" (NCC) model.

Example: forward grain market: one ton of grain will be delivered to a buyer 91 days from today:

SP (of grain) = LCC1 200 per ton

ir = 12.0% pa

dte = 91

t = 91 / 365

SC = 35 cents per ton per day

FP = {LCC1 200 x [1 + (0.12 x 91 / 365)]} + (0.35 x 91)

= (LCC1 200 x 1.0299) + LCC31.85

= LCC1 267.75 per ton.

2.11. Forwards on derivatives

In addition to the forwards that are found in the four financial markets, there are also forwards on swaps.

The specific swaps on which forwards are written are interest rate swaps (IRSs). The forward IRS is an agreement to enter into a swap at some stage in the future at terms agreed upfront. It differs from a swaption (discussed later) in terms of which the holder has the right to allow the option to lapse. In the case of a forward swap, the holder is obliged to undertake the swap at the future agreed date (swaps are discussed in some detail later).

2.12. Organisational structure of forward markets

Figure 14 is one way of depicting the organisational structure of the spot financial markets.

organisational structure of spot financial markets

Figure 14: organisational structure of spot financial markets

organisational structure of derivative financial markets

Figure 15: organisational structure of derivative financial markets

However, this applies to the "normal" financial markets, i.e. the money, bond and share markets. It is not well suited to the foreign exchange and derivative markets. Figure 15 is an attempt to visualize the derivative markets.

The derivative markets in the form of the OTC forward markets are entirely primary markets (there are minor exceptions such as repos that are marketable, but trading in them is rare); thus, generally, one cannot talk of a secondary OTC derivatives market (in the normal sense of the term). The reason for this situation is that the forward market instruments are usually custom made for clients. However, this does not mean that the holder of a forward transaction is "stuck" with the deal until maturity; the instruments are "marketable" in the sense that the positions created by them may be "closed out" quite easily by the purchase / sale of an opposite deal. The "closing out" will result a net loss or profit, as in the case of a spot instrument sale.

The same applies in the case of listed (on an exchange) forwards, but with a difference. A secondary market in these listed instruments also does not exist in the normal sense of the term. However, the contracts are standardized and can therefore be "closed out" by doing an equal but opposite transaction. In the case of the OTC forward markets it is not always possible to do the exact opposite transaction, leaving thus a measure of risk.

This brings us to the trading driver: quote or order. Participants are able to get quotes from the banks or place an order with a broker-dealer. "Quote" means that the banks provide quotes (as in market making - explained earlier). This leads to the trading system. In the Local Country's derivative markets, all the trading systems apply (except "floor"; it does however still apply in some international markets).

The trading system "telephone / screen" means applies where broker-dealers quote indication prices on the screen (for example, the Reuters Monitor System) and clients phone in and ask for firm prices. "Screen / telephone" is where prices quoted on screen are firm for a certain size deal and the deal is consummated on the telephone. ATS stands for "automated trading system" and here deals in the form of orders are inputted into the ATS and are matched by it if there is an opposite order. The various types of forward transactions fit into one of these three trading systems.

Single and dual capacity trading means that the broker-dealers either act as brokers and dealers (dual) or as brokers or dealers (single).

2.13. Summary

Forward contracts are to settle assets / securities on dates in the future other than spot settlement dates. Some markets are suited for forward contracts such as the forex market and the FRA market. There are forwards in all the markets: debt, share, forex and commodities. The pricing of forwards rests on the cost of carry model, i.e. the rate of interest for the relevant period less income (if applicable).

2.14. Bibliography

Bodie, Z, Kane, A, Marcus, AJ, 1999. Investments. Boston: McGraw-Hill/Irwin.

Faure, AP, 2005. The financial system. Cape Town: QUOIN Institute (Pty) Limited.

Hull, JC, 2000. Options, futures, & other derivatives (4e). London Prentice-Hall International, Inc.

McInish, TH, 2000. Capital markets: A global perspective. Massachusetts, USA: Blackwell Publishers Inc.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions (3e). Reading, Massachusetts: Addison-Wesley.

Rose, PS, 2000. Money and capital markets (international edition). New York: McGraw-Hill Higher Education.

SAFEX (Financial Derivatives and Agricultural Products Divisions of the JSE Securities Exchange South Africa), 2003. [Online]. Available: [Accessed October].

Saunders, A, 2001. Financial markets and institutions (international edition) New York: McGraw-Hill Higher Education.

Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (2e). Boston:. McGraw-Hill/Irwin.

Spangenberg, P, 2000. Forward rate agreements. The Southern African Treasurer. 14. September.

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