In stock market shares are traded in spot market as well as in forward market. In the spot market, there is delivery of shares against payment. But in forward market an agreement is for future payment and delivery. This may or may not materialize. But, the purpose of entering into forward market is to prevent any fall in the price of shares which is an insurance against the risk of fluctuating prices. This is called Hedge.
In financial market, risks arise due to the fluctuation in the price of securities or due to a change in the interest rate on debt instruments. So, to protect these, the financial companies undertake derivative contract in the forward or futures markets by which they protect themselves from falling prices or interest rates.
What is a Forward market?
A forward market is a contract entered into between a buyer and seller for future delivery of stock or currency or commodity. The buyer in a forward contract gains if the price at which he buys is less than the spot price and he will lose if the price is higher than the spot price.
What is the purpose of forward contract in a forward market?
The purpose of the forward contract is to protect the seller or buyer against any fluctuations in the price. If the seller or the buyer incurs loss in a forward contract, they can compensate the same by reversing the contract and selling or buying at lower or higher prices, according to their positions. Thus, a forward market is a hedge against fluctuating prices. This applies to stock, currency as well as goods.
Forward Market classification:
Forward market can be classified as
- commodity forward, and
- financial forward.
In financial forward, we have currency contracts. There is also forward market on interest rate and the agreement reached in the forward market for interest rate is called forward rate agreement. Such agreements are entered into when traders expect an increase in demand for funds in the next 3 or 4 months.
What is a futures market?
Though futures market is similar to forward market, it comes under regulated organizations in which members alone are permitted to transact. The futures market will have its own rules and regulations and will also fix the minimum value for each transaction. Here again, the purpose is to smooth out the price fluctuation so that neither the buyer nor the seller incurs heavy loss due to price fluctuations.
Futures market can be classified as
- commodity future, and
- financial future.
Benefits of Forward and Futures Markets
Forward and futures markets protect against price fluctuations:
Any expectation in the price increase or any decline in the same can be protected by entering into forward contracts to buy or sell at a particular price.
Forward and futures markets provides the option of buying and selling:
The buyer or seller can exercise their option and if they are not keen to execute the contract they can opt out by paying a nominal amount.
They enable the buyer or seller to make proper arrangements for finance:
Since the transactions are for future buying or selling, suitable financial arrangements could be done by proper planning.
Investors can plan their future investments:
Based on the forward or future market, investors can plan their investments either by shifting it from the existing investment or by borrowing and going in for new investments.
Cash crunch does not arise owing to these markets:
As the transactions do not involve payments in bulk and with buying and selling of securities or currencies, only marginal amount is involved.
Forward and futures markets helps in large transactions:
With more people entering the market, volume of transactions increases along with frequent turn over of transactions.
Flexibility in forward and futures markets:
They are very flexible contracts enabling the buyer or seller to opt out by paying a small margin amount. The market provides flexibility, as simultaneously a person can buy and sell in different markets due to the development of Information Technology.
Forward and Futures markets reduce risks for financial companies:
The forward and futures market has improved financial services and financial companies are able to reduce their risks. With various credit instruments available and resources made available from various sources, the financial companies are in a position to earn good profits even with a very low margin in their price. This is due to the higher volume of trade. The market is also attracting funds from foreign countries. So, the financial companies with various financial products are able to have better returns for their investment.
Mutual fund companies are able to have better portfolio investment due to forward contracts and hedging against price fluctuations.