In this blog we have discussed many aspects of forward contracts and forward markets. We will conclude the post (and each of the following posts, which cover futures, options, and swaps) with a brief discussion of the role that these markets play in our financial system. Although forward, futures, options, and swap markets serve similar purposes in our society, each market is unique. Otherwise, these markets would consolidate.
Forward markets may well be the least understood of the various derivative markets. In contrast to their cousins, futures contracts, forward contracts are a far less visible segment of the financial markets. Both forwards and futures serve a similar purpose: They provide a means in which a party can commit to the future purchase or sale of an asset at an agreed-upon price, without the necessity of paying any cash until the asset is actually purchased or sold. In contrast to futures contracts, forward contracts are private transactions, permitting the ultimate in customization. As long as a counterparty can be found, a party can structure the contract completely to its liking. Futures contracts are standardized and may not have the exact terms required by the party. In addition, futures contracts, with their daily marking to market, produce interim cash flows that can lead to imperfections in a hedge transaction designed not to hedge interim events but to hedge a specific event at a target horizon date. Forward markets also provide secrecy and have only a light degree of regulation. In general, forward markets serve a specialized clientele, specifically large corporations and institutions with specific target dates, underlying assets, and risks that they wish to take or reduce by committing to a transaction without paying cash at the start.
Forward contracts are just miniature versions of swaps. A swap can be viewed as a series of forward contracts. Swaps are much more widely used than forward contracts, suggesting that parties that have specific risk management needs typically require the equivalent of a series of forward contracts. A swap contract consolidates a series of forward contracts into a single instrument at lower cost. Forward contracts are the building blocks for constructing and understanding both swaps and futures. Swaps and futures are more widely used and better known, but forward contracts play a valuable role in helping us understand swaps and futures. Moreover, as noted, for some parties, forward contracts serve specific needs not met by other derivatives.