What is Forward Rate and Spot Rate?
If you have been trading in the commodity markets or the forex markets, you would be quite familiar with the concept of spot rates and forward rates. Let us look at what is spot rate is before we try and understand the forward rate meaning. Firstly, the spot rate meaning is the price of an asset that is currently available and traded. Spot rates are always the rates for delivery today or for immediate delivery.
Forward rates, on the other hand, refer to rates at a future date, maybe after 1 month or 3 months or 6 months. While the spot rate is not something that needs much of a discussion, we will constantly come back to the topic of spot rates when we discuss forwards and futures. However, what is important and instructive is to grasp the difference between forwards and futures.
Concept of Forwards versus futures
Both forwards and futures pertain to the delivery of an asset at a future date. Here are some key points to understanding the difference between forwards and futures.
- The first thing is how these contracts are settled. Futures are settled daily based on MTM and finally on the expiry of the contract. Forwards are settled on the maturity date as negotiated between the parties and put down in the contract.
- The second difference pertains to regulation. The futures market is normally regulated by nodal agencies like the RBI, SEBI, etc. Forwards are normally self-regulated although some products like the rupee forward contracts are regulated by the RBI.
- Futures contracts stipulate the payment of upfront and daily MTM margins on all open positions being carried by clients. Forwards are based on good faith among large institutions and hence they normally do not entail margins.
- Since futures are standardized, they mature only on a specified date and this applies to all contracts with that particular maturity. In the case of forwards, each contract has a unique maturity date.
Forward markets versus spot markets
Till now we have seen the differences between forwards and futures. While it is OK to use these terms interchangeably on a conceptual basis, it is also essential that the finer points of differences are understood. Fundamentally, forwards and futures entail a commitment to a transaction at a future date at an agreed price. On the date of the expiry, if Spot Price is higher than the contracted price then the buyer benefits. On the other hand, if on the expiry date, the Spot Price is lower than the contracted price then the seller benefits. To understand forwards better, we look specifically at two popular forward contracts in India viz. the commodity forwards and the rupee/dollar forwards. Remember that the forward rate is nothing but the expected spot rate. In turn, the spot rate is nothing but the adjusted present value of the forward rate.
Understanding commodity forwards in India
Most Commodity Markets in India offer trading in forwarding contracts. To understand forward market contracts, one needs to understand spot contracts a little more closely. In a spot market contract, the payment and the delivery of the commodity are instantaneous. Practically, you cannot deliver 10 tonnes of cotton instantly so that spot contract will be executed using an audited Warehouse Receipt (WR) and actual delivery will happen later.
On the other hand, forward contracts entail payment and delivery at a future date, but the price and the quantity are decided today. While reference is the spot rate, the contract is at the forward rate. A forward contract can only be for the delivery of a particular commodity and not for speculation; unlike commodity futures. It is for this reason that privately designed forward contracts executed at forwarding rates based on spot rates are extremely popular among large corporates looking to hedge commodity price risk.
Understanding dollar forwards in India
One of the most popular examples of a forwarding market in India is the Dollar Forward Market. In a dollar-forward contract; importers, exporters, and foreign currency borrowers hedge their risk. How is this done? An importer and foreign currency borrower having dollar payables need to hedge against a strengthening of the dollar. On the other hand, an exporter needs to hedge against the weakening of the dollar. Currency futures are available on NSE and BSE to hedge currency risk.
The preferred mode for hedging dollar risk is still the dollar forward market due to its size and flexibility. Firstly, hedging requirements are unique to players and forward contract matching is much simpler. Secondly, key participants in the Dollar Forward markets are generally commercial banks and large financial institutions so counterparty risk is low.
How is the currency futures market different from the forward market?
There are some basic parameters on which the currency futures market is different from the forwards market. Here are a few key areas of difference.
- While the currency forward market is an OTC market, the futures market is exchange-traded. That means contracts on the currency futures market are structured by the exchange and guaranteed by the clearing corporation.
- The currency futures market based on futures rates is a guaranteed market free of counterparty risk. All trades on the currency futures exchange are guaranteed by the clearing corporation. On the other hand, the rupee forward market is an OTC market that does carry technical counterparty risk. However, since participants are large banks and institutions, this risk is more theoretical.
- Transaction lot sizes are much smaller in the currency futures exchange, for example, it is as small as $1000 of notional value. In the case of currency forwards, the value of the contract runs into millions of dollars to make the structure viable. Most banks will not be willing to write a forward cover unless it has a certain minimum size.
- A forward cover in the dollar forward market can only be taken against an underlying open currency position. You should necessarily have a foreign currency receivable or a foreign currency payable. Banks don’t permit forwards for speculation purposes. There are no such conditions in the currency futures market. You can even speculate on currency futures based on your view on the dollar, pound, yen, etc. That is possible as all currency futures positions are cash-settled in India.
- The rupee forward market and the currency futures market can be used to hedge currency risk. However, the forward market is a delivery market and all transactions must result in actual delivery or purchase of dollars. In the currency futures market, all transactions are settled in cash. Hence it is easier to speculate in the currency futures market.
Challenges in trading in forwarding markets
The biggest challenge in the forward market mechanism is the lack of price discovery. The forward rate is based on the spot rate but the actual forward rate pricing is still too dependent on a handful of banks as in the case of rupee-dollar forwards. When contracts are customized in quantum and specifications, it is very difficult to bring about price discovery, so the forward rates are not as market reflective as futures rates. Since these forward rates eventually influence spot rates, the scope for manipulation in such forward rates is a distinct possibility. We have seen how forward rates were manipulated in the LIBOR trades.
This is something futures markets are more adept at doing. Then, of course, there is the major issue of counterparty risk which remains a major challenge to the development of forwarding markets. Lastly, for a long time, the forward market has had serious entry barriers. Take the case of the Dollar Forward market. It is still dominated by a handful of banks and large institutions. The need for scale in forwarding markets makes it impossible for small and mid-sized investors to participate meaningfully in forwarding markets.
What are futures?
Futures are forward contracts that are exchange-traded. Classic examples of futures are index futures, stock futures, USDINR futures, Gold Futures, etc. These products are standardized so there is no issue of liquidity. Also, they are covered by a counter-guarantee by the clearing corporation that clears the trades so any counterparty risk is eliminated from futures transactions.
Can i buy futures of global stocks?
Currently, Indian citizens are allowed to have global investments via the Outwards Remittance Scheme that permits up to $2.50 lakhs per year. To that limit, you can use it for buying and selling foreign assets. However, a much better way would be to participate in global stock futures through index ETFs.
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Frequently Asked Questions
The forward rates represent expected spot rates. In the case of commodity futures, the represent the cost of carry which is the cost of interest plus storage and insurance. In the case of currency futures, the forward rate reflects the difference between the interest rates in the two countries, which normally determines the extent of spot-forward spread.
For example, if the 1-year interest rate in the US is 2% and in India it is 6%, the US$ would trade at a 4% premium against the Rupee. In other words, the Indian rupee will have to weaken by 4% each year to be at par and compensate for the interest rate differential. If USD/INR spot rate is 70, the 1-year forward rate would be 72.80. This forward price of Rs.72.80 is referred to as the zero-arbitrage forward price. If the 1-year forward trades at any rate other than Rs.72.80, it provides a trading opportunity.
Forward rates are determined by the forces of demand and supply. However, in the case of forwards like the dollar forwards, it is a handful of powerful and large banks that decide the forward rates as the weighted average of quotes and that sets the trend for the day.
Forward rates for the rupee / dollar are made available at the banks or authorized dealers but being a closed market, it is normally not made public.