Lesson 5 of 10
People may use a forward contract for a variety of reasons, for example, a farmer may want to lock-in the price of its crop that will be available for sale after three months, or an importer may want to lock-in the exchange rate at which it will make the future payment for imports. These people are the hedgers who have a risk that they want to mitigate. These end users will usually be corporations, non-profit organizations, and government entities. The typical users are farmers, manufacturers, importers and exporters.
Assume that a US importer has imported some goods from India and is expected to make the payment in Indian Rupees (INR) after 90 days. Since the US importer doesn’t have control over the exchange rate after 90 days, there is foreign exchange risk in this transaction. The importer can enter into a forward contract to purchase the required amount of Indian Rupees for a fixed amount of US dollars after 90 days. This way the US importer knows exactly how much it will pay in terms of US dollars after 90 days.
Apart from hedging purpose, there are also market participants who want to benefit by taking risk in futures and forwards market. These are the speculators who want to benefit from fluctuations in prices. So, while hedgers want to reduce their risk, speculators want to take risk.
Since the forward contracts are not traded on any exchange, the end users need to find a counterparty for the contract. The end-users will use a dealer to find the counterparty that will be willing to take the opposite position. The dealer may itself take the opposite position or will find a counterparty. It is important to note that, unlike an agent, a dealer will actually take the position and will have a long or short position in the contracts. Dealers will usually balance their long and short positions by entering into long and short positions in different forward contracts. They will earn a spread on the price difference between the long and short position. The dealer’s desk will quote a buying price to take a long position, and a selling price to take a short position. The selling price will be a bit higher than the buying price, and the dealer will earn the bid/ask spread.
Apart from the end users, the dealers will also enter into forward contracts with other dealers in order to hedge their own long/short positions.
The dealers are usually the banks and other security dealers.