Definition of Forward Market

Forward Market

The 1- or 2-day delivery period for spot transactions is so short that when comparing spot rates with forward exchange rates we can usefully think of spot rates as exchange rates for undelayed transactions. On the other hand, forward exchange rates involve an arrangement to delay the exchange of currencies until some future date. A useful working definition is:

The forward exchange rate is contracted today for the exchange of currencies at a specified date in the future. Forward rates are generally expressed by indicating premium/ discount on the spot rate for the forward period.

Premium on one country’s currency implies discount on another country’s currency. For instance if a currency (say the US dollar) is at a premium vis-à-vis another currency (say the Indian rupee), it obviously implies that the Indian rupee is at a discount vis-à-vis the US dollar.

The forward market is not located at any specified place. Operations take place mostly by telephone/telex, etc., through brokers.

Generally, participants in the market are banks, which want to cover orders for their clients. Though a trader may quote the forward rate for any future date, the normal practice is to quote them for 30 days (1 month), 60 days (2 months), 90 days (3 months) and 180 days (6 months).

Quotations for forward rates can be made in two ways. They can be made in terms of the exact amount of local currency at which the trader quoting the rates will buy and sell a unit of foreign currency. This is called ‘outright rate’ and traders in quoting to customers use it. The forward rates can also be quoted in terms of points of premium or discount on the spot rate, which used in inter-bank quotations.

To find the outright forward rates when premium or discount on quotes of forward rates are given in terms of points, the points are add to the spot price. If the foreign currency is trading at a forward premium; the points are subtracted from spot price if the foreign currency is trading at a forward discount.

The traders know well whether the quotes in points represent a premium or a discount on the spot rate. This can be determined in a mechanical fashion. If the first forward quote (the bid or buying figure) is smaller than the second forward quote (the offer or the asking or selling figure), then there is a premium.

In such a situation, points are added to the spot rate. Conversely, if the first quote is greater than the second then it is a discount.

If, however, both the figures are the same, then the trader has to specify whether the forward rate is at premium or discount. This procedure ensures that the buy price is lower than the sell price, and trader profits from the spread between the prices.

It may be noted that in the case of forward deals of 1 month and 3 months, US dollar is at discount against French Franc (FF) while 6 months forward is at premium. The first figure is greater than second both 1 month and 3 months forward quotes. Therefore, these quotes are at discount and accordingly these points have been subtracted from the spot rates to arrive at outright rates. The reverse is the case for 6 moths forward.

Example

Let us take an example of a quotation for the US dollar against rupees, given by a trader in New Delhi.

The outright rates form this quotation will be as below:

Here, we notice that the US dollar is at premium for all the three forward periods. Also, it should be noted that the spreads in forward rates are always equal to the sum of the spread of the spot rate and that of the corresponding forward points. For Example, the spread of 1month forward is 0.0140 (=0.0090+0.0050), and, so on.