An Overview Of Forward Markets And How They Differ From Spot Markets

January 18, 2023
Photo by Nataliya Vaitkevich from Pexels

The foreign exchange market is one of the most exciting places for traders. The market’s volatility brings risk but also the potential for massive profits. Many traders, early in their careers, will be familiar with spot rate exchanges – they are the most common and easiest to perform.

The forward market is trickier to master but offers benefits spot rate traders miss. To gain an advantage, you need to know where to start.

Our guide gives you the overview you need. Read to learn about forwards.

What Is a Forward Market?

Forward markets are where traders agree to a future date for an exchange. The price is set at the date of the agreement, and the future price is determined using interest rates. Unlike futures contracts, forwards contracts can be adapted to the needs of both parties, and they offer both benefits and risks on the forex market.

Forward prices use interest rate differences between the two currencies to work out the forward price. Forward exchanges are usually between two banks or a bank and a consumer. Though customisable, the most popular forward dates are between 3 to 6 months from the agreement.

For forex, forward trades can work as swaps or outright transactions. For outright forwards, one party agrees to buy a currency with their own and deliver it on the maturity date. Delivery can be any working day after the spot date.

How Do Forward Markets Differ from Spot Markets?

Spot markets set the exchange price based on the spot rate at the time. The global foreign currency exchange sets the spot rate. They use economic and political factors to do this: interest rates, inflation, growth, supply, demand and relative value.

Spot rates are best for immediate trades on forex. Well-informed traders can predict spot rates to a degree, allowing them to capitalise at the right moment. Forex’s volatility means most traders use spot rates for fast exchanges – they can react to economic and political factors as they arise.

Forward traders commit to a set future date and a set price. This requires research and knowledge of future market developments. Once you have set a price, you must pay it on or before the maturity date. This holds true regardless of what happens in the market between now and then.

How Can Forward Markets Benefits Traders?

Traders can customise forward contracts to a greater degree than futures. It is a self-regulated market, offering greater freedom in terms of duration, contract size and specific needs.

Forwards let you profit from accurate speculation. If your research suggests a currency will rise in the coming months, you can set a profitable rate and gain a bargain investment at maturity. Once you have your deliverables, you will thank yourself for using forwards instead of spot rates.

You can also use forwards for hedging, protecting your investments from exchange rate losses. Forex hedging can limit your downside risk and protect from losses. When the market is in your favour, use a forward contract to guarantee a future exchange price.

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