FINANCE “YOGA with Emmanuel Inyada: Forwards
Issue #8: Forwards
In this Issue of Finance “Yoga” with Emmanuel Inyada, we continue with our discussion on derivatives. We will be looking at a third type of derivative- that is, Forwards.
Let’s get right in!
The word “forward” is derived from the old English word “forthweard” or “forward” meaning “towards the future”. The word is said to have been first used in the 1400s. However, there are indications that it may have been used earlier.
In finance, the term “forwards” also expressed as “forward contract” is a customised or non-standardised derivative contract that places an obligation upon the parties to buy or sell a particular asset or commodity at specified price and at a predetermined time or date in the future.
Breaking the definition down in bits. Forwards are:
(a) derivative financial contracts
(b) which are customised or non-standardised unlike futures which are standardised
(c) that places an obligation to buy or sell an asset at a specified price on a future date.
The underlying asset or commodity could be oil, natural gas, cash crops, precious metals, securities, interest rate etc. I hope this is simple enough. Okay, let’s proceed!
Forward contracts can be tailored towards a particular commodity or future date. Also, forwards, like most derivatives, are used to hedge against market risks or for speculation. Its non-standardised nature, however, makes it attractive for hedging.
Their non-standardised nature means that forwards do not trade on a centralised exchange. They are better traded over-the-counter (OTC). Thus, they are referred to as OTC instruments.
Their OTC nature makes it easier to customise terms of the contract. This also means that forwards do not operate through a centralised clearing house. This, thus, increases the degree of default risk.
Distinguishing Between Forwards and Futures
- Settlement for forwards takes place at the end of the contract whilst futures may take place on a daily basis.
- Forwards are customised derivative contracts whilst futures are standardised or non-customised.
- Forwards makes use of an OTC because it makes it easier for parties to customise terms of the contract. Futures makes use of a centralised clearing house due to its standardised nature.
In all, forwards are more flexible than futures.
Usage in a Sentence
So now we can say:
“Dozie encouraged the preferential use of forwards contract.”
“There has been a steady increase in the range of assets traded in the forwards market for about ten years now.”
“The SEC decided to make the capital market more robust by passing regulations that will fast-track growth with respect to the trade in forwards.”
That will be all for this issue on Finance “Yoga with Emmanuel Inyada. There is so much more you can learn about derivatives especially forwards especially with respect to its varied application in today’s capital market.
While learning, it is imperative to have fun. Remember, finance is not that hard!See you next week!
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