Background - Forwards Market
Background - Forwards Market​
The forwards market is a foundational concept in the world of financial markets. It involves contracts where two parties agree to buy or sell an asset at a predetermined price on a specific future date. These contracts are not standardised and are typically traded over-the-counter (OTC), meaning they are customised to meet the specific needs of the buyer and seller. Forwards are widely used for hedging, speculation, and risk management in various markets, including commodities, currencies, and securities.
How Forwards Work​
Imagine a coffee producer who fears a drop in coffee prices in six months. To mitigate the risk, they enter into a forward contract with a buyer (say, a coffee distributor). They agree on a fixed price today for the coffee to be delivered in six months. The producer benefits if prices drop because they have secured a higher rate, while the buyer benefits if prices rise, as they’ve locked in a lower price.
Forwards are often the first step toward understanding more complex trading instruments like futures and options, which are central to AlgoTest’s platform.
Key Characteristics of Forwards​
- Customization: Forwards are private contracts and are highly customizable. This is different from futures, which are standardised and traded on exchanges.
- Risk of Default: Since forwards are not regulated by an exchange, there is a risk that one party may default on the contract. This is known as counterparty risk.
- No Daily Settlement: Unlike futures, forwards don’t have a daily settlement process. This means gains and losses are realised at the end of the contract.
Forwards and AlgoTest​
At AlgoTest, traders engage with sophisticated instruments like options and futures, but understanding forwards can sharpen risk management skills. Although forwards are not directly used in options trading, they help illustrate fundamental hedging techniques. When you use our Strategy Builder to create option strategies or run simulations, the concept of securing a future price (like a forward contract) can influence decisions like buying puts or calls to protect against price movements.
Fun Example with a Chart​
Let’s say you’re a trader on AlgoTest, and you want to hedge a position on AXIS BANK stock. You believe the stock price will drop in the next three months, so you enter into a forward contract to sell it at today’s price of ₹800 per share. If the price drops to ₹700, you’ve saved ₹100 per share, effectively reducing your risk. However, if the price rises to ₹900, you lose out on the ₹100 gain. This is the risk-reward dynamic that makes forwards a valuable hedging tool.
Here’s a simple chart to help visualize this concept:
| Price (in ₹) | Scenario |
|---|---|
| 900 | Loss of ₹100 per share |
| 850 | Loss of ₹50 per share |
| 800 (Forward) | No profit, no loss (Break-even) |
| 750 | Gain of ₹50 per share |
| 700 | Gain of ₹100 per share |