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| Forward Market |
On the forward market, delivery is at a future point in time rather than spot. Nevertheless, prices are fixed at the initiation of the contract. Trading takes place over-thecounter (OTC). This means that contracts are traded directly between counterparties (e.g., banks and their customers) and not on an exchange.
Forward contracts enable companies to hedge their exposure, for example, to exchange rate movements. Consider for instance a U.S. company that runs a business in Germany.
The U.S. company expects to earn €10 million in 6 months. This corresponds to substantial exchange rate risk. If the euro depreciates by say 0.1 dollar per euro, then the profit decreases by $1 million.
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In order to hedge this exposure the company may enter a forward contract in which it sells €10 million in 6 months to its bank. Since the price of the euro in terms of dollar is fixed today, the U.S. company knows exactly how many dollars will be obtained for delivering euros.
Alternatively, the company may also trade futures contracts. In contrast to forward contracts, futures prices are determined on an exchange. One may argue that this leads to better pricing.
Nevertheless, one must not forget that (at least) the FX forward market is very liquid and pricing can therefore be considered as competitive. Furthermore, futures contracts may require substantial intermediate payments due to the mark to market practice, which must be financed with cash.
Furthermore, contract specifications like the settlement date can be tailored to the specific needs of the counterparties as opposed to the standardized contracts on future exchanges.
