Forward, Futures and Options Market
A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, but the term is primarily used with reference to the foreign exchange market. It can also it can also apply to markets for securities and interest rates as well as commodities.
A forward market leades to the creation of forward contracts. While forward contracts, like futures contracts, may be used for both hedging and speculation, there are some notable differences between the two. Forward contracts can be customized to fit a customer’s requirements, while futures contracts have standardized features in terms of their contract size and maturity. Forwards are executed between banks or between a bank and a customer; futures are done on an exchange, which is a party to the transaction. The flexibility of forwards contributes to their attractiveness in the foreign exchange market.
Prices in the forward market are interest-rate based. In the foreign exchange market, the forward price is derived from the interest rate differential between the two currencies, which is applied over the period from the transaction date to the settlement date of the contract. In interest rate forwards, the price is based on the yield curve to maturity.
Foreign Exchange Forwards
Interbank forward foreign exchange markets are priced and executed as swaps. This means that currency A is purchased vs. currency B for delivery on the spot date at the at the spot rate in the market at the time the transaction is executed. At maturity, currency A is sold vs. currency B at the original spot rate plus or minus the forward points; this price is set when the swap is initiated. The interbank market usually trades for straight dates, such as a week or a month from the spot date. Three- and six-month maturities are among the most common, while the market is less liquid beyond 12 months. Amounts are commonly $25 million or more and can range into the billions.
Customers, both corporations and financial institutions such as hedge funds and mutual funds, can execute forwards with a bank counter-party either as a swap or an outright transaction. In an outright forward, currency A is bought vs. currency B for delivery on the maturity date, which can be any business day beyond the spot date. The price is again the spot rate plus or minus the forward points, but no money changes hands until the maturity date. Outright forwards are often for odd dates and amounts; they can be for any size.
The most commonly traded currencies in the forward market are the same as on the spot market: EUR/USD, USD/JPY and GBP/USD.
Currencies for which there is no standard forward market can be traded via a nondeliverable forward. These are executed off-shore to avoid trading restrictions, are only executed as swaps and are cash-settled in dollars or euros. The most commonly traded currencies are the Chinese remnimbi, South Korean won and Indian rupee.
Like option, future helps to manage risk. Futures contracts are products created by exchanges. A futures contract is an agreement that requires a party to a agreeing either to sell or buy something at a designated future date at a predetermined price. As the value of a futures contract is derived from the value of the underlying instrument they are commonly called derivative instruments.
The basic economic function of futures markets is to provide an opportunity for market participants to hedge against the risk of adverse price movement. The futures contracts based on a financial instrument or a financial index are known as financial futures. Financial futures can be classified as stock index futures, interest rate futures, and currency futures.
Financial futures contracts exist to provide risk management services to participants. Risk and uncertainty in the form of price volatility and opportunism are major factors giving rise to future trading. Futures trading evolved out of autonomous forward contracting by merchants, dealers and processors, designed to increase business efficiency.
Indeed, early futures markets were viewed as delivery markets in which transactions were facilitated by the provision of uniform rules on grade and delivery terms, and the security provided by the clearing houses in guaranteeing individual contracts.
This evolution from spot, to forward, to futures contracts suggest a progressive adaptation of institutions to more efficient methods of dealing with price risk.
It is frequently argued that a pre-condition for futures trading is a well developed cash market and the breakdown of forward contracting. Futures markets develop because they are a more efficient means of transferring those contract rights attached to price. Spot and forward contracting may become too costly.
However, these three contracting modes are not mutually exclusive ways of transacting. Indeed, the development of futures markets improve the efficiency of spot and possibly of forward contracting.
It is perhaps best to view futures markets as ‘side’ markets designed to deal with price volatility that is poorly handled by spot and forward markets. This transactional superiority of futures markets comes mainly from their transaction – cost reducing attributes.
Futures markets, by forming prices relating to forward delivery dates, project their prices into the future. These prices are used by agents to plan future production to price forward contracts for the supply of commodities, and to tender for forward contracts.
Agents need not transact on future exchanges to use futures prices in this way, and the information contained in such prices is an externality to them. Agents may also use futures markets in deciding whether to store a commodity (using the forward premium as an indicator of whether storage is expected to be profitable).
In addition, futures markets may help agents to decide the timing of inputs purchases and of processing activities according to the expected outcome of hedging. Agents in these latter two categories are, of course, transistors on futures markets.
Thus, futures markets perform a forward pricing function, and in these ways futures prices facilitate the allocation of resources between present and future uses.
There are many different types of options that can be traded and these can be categorized in a number of ways. In a very broad sense, there are two main types: calls and puts. Calls give the buyer the right to buy the underlying asset, while puts give the buyer the right to sell the underlying asset. Along with this clear distinction, options are also usually classified based on whether they are American style or European style. This has nothing to do with geographical location, but rather when the contracts can be exercised. You can read more about the differences below.
Options can be further categorized based on the method in which they are traded, their expiration cycle, and the underlying security they relate to. There are also other specific types and a number of exotic options that exist. On this page we have published a comprehensive list of the most common categories along with the different types that fall into these categories. We have also provided further information on each type.