Page 47 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 3.3 Benefits and Limitations of Forward Markets

The following are some of the benefits of the forward markets:
1. Forward contracts can be used to hedge or lock-in the price of purchase or sale of commodity
or financial asset on the future commitment date.
2. On forward contracts, generally, margins are not paid and there is also no upfront premium.
So, it does not involve initial cost.

3. Since forwards are tailor-made, price risk exposure can be hedged up to 100%, which may
not be possible in futures or options.
The following are some of the limitations of the forward markets worldwide:

1. Lack of centralisation of trading,
2. Illiquidity, and
3. Counterparty risk

In the first of these two, the basic problem is that of too much flexibility and generality. The
forward market is like a real estate market in that any two consenting adults can form contracts
against each other. This often makes them design terms of the deal which are very convenient in
that specific situation, but makes the contracts non-tradable. Counterparty risk arises from the
possibility of default by any one party to the transaction. When one of the two sides to the
transaction declares bankruptcy, the other suffers. Even when forward markets trade standardised
contracts, and hence avoid the problem of illiquidity, the counterparty risk still remains a very
serious issue.
However, following are some other disadvantages of forward contracts:
1. Counterparty risk is very much present in a forward contract since there is no performance
guarantee. On due date, the possibility of counterparty’s failure to perform his obligation
creates another risk exposure.
2. Forward contracts do not allow the investor to derive any gain from favourable price
movement or to unwind the transactions once the contract is made. At the most, the
contract can be cancelled on the terms agreed upon by the counterparty.
3. Since forwards are not exchange-traded, they have no ready liquidity. Further, it is difficult
to get counterparty on one’s terms.

4. One of the counterparties of these contracts is generally a bank or trader who square up
their position by entering into reverse contract. These transactions do not take place
simultaneously, so these parties normally keep large bid-ask spread to avoid any loss due
to price fluctuations. This increases the cost of hedging.

Task Collect the data of forward agreements for 2012 and analyse the growth of forward
contracts in India in comparison to other developing countries.

Self Assessment

State whether the following statements are true or false:

6. Counterparty risk arises from the possibility of default by both the party to the transaction.

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