What is the liquidity risk of forward contracts?
Liquidity: Forward contracts have lower liquidity than futures contracts. This is because forward contracts are not traded on exchanges, while futures contracts are traded on exchanges. Exchange-traded contracts are more liquid because there are more buyers and sellers in the market.
Risks involved while trading in Forwards Include, liquidity risk, default risk, regulatory risk and lack of flexibility. The main areas of differences between Forwards and Futures lie in their contract terms, their default risk, regulation, initial margin and settlement.
Liquidity risk is the risk of not being able to find a counterparty to a trade at a fair market price. The advantage of futures contracts is that the contracts are all standardized. By having standard contracts it is easier to find multiple interested counterparties.
It's more common for futures to be settled in cash, while forwards are often settled in the asset. The futures market is highly liquid, making it easy for investors to buy and sell whenever they want to, whereas the forwards market is far less liquid, adding additional risk.
Their use is limited by three major problems with forward contracts: (1) it is often costly/difficult to find a willing counterparty; (2) the market for forwards is illiquid due to their idiosyncratic nature so they are not easily sold to other parties if desired; (3) one party usually has an incentive to break the ...
Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.
There is credit risk involved in forward contract because the counterpart may not deliver the asset to you at the time of delivery. Since a forward contract is not exchange traded, a buyer or seller cannot lock in gains/losses on the contract's value prior to the agreed settlement date.
An example of liquidity risk would be when a company has assets in excess of its debts but cannot easily convert those assets to cash and cannot pay its debts because it does not have sufficient current assets. Another example would be when an asset is illiquid and must be sold at a price below the market price.
Liquidity risk is the risk of loss resulting from the inability to meet payment obligations in full and on time when they become due. Liquidity risk is inherent to the Bank's business and results from the mismatch in maturities between assets and liabilities.
However, this risk does not exist in the case of exchange-traded derivatives, as the clearing house or clearing corporation acts as the counterparty. Liquidity risk is another significant one. It refers to the risk that an investor may not be able to exit a position in the derivative market quickly or at a fair price.
Are forward contracts less liquid?
The key difference is that futures contracts, traded on exchanges, are standardized with greater liquidity and reduced credit risk, while forward contracts, traded over-the-counter, are bespoke agreements offering flexibility but carry a higher risk of counterparty default.
An investor who prefer more liquid contracts will settle for a futures contract while an investor who requires a more customized contract will engage in a forward contract.
1. Opportunity Cost: One of the main disadvantages of forward contracts is the opportunity cost of locking in a specific exchange rate. If the exchange rate moves in favor of the business, they may miss out on potential gains by being locked into a less favorable rate.
There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC). Forwards have more counterparty risk than futures.
Bilateral: Forward contracts are bilateral contracts, and hence, they are exposed to counter- party risk. More risky than futures: There is risk of non- performance of obligation by either of the parties, so these are riskier than futures contracts.
Futures are marked to market daily, meaning they are settled every day until the contract's expiration date. Forwards involve considerable risks for one of the parties. Futures contracts imply negligible risks for both counterparties. Transaction markings only occur twice: on the purchase and settlement dates.
In the case of forward contracts, their holders often require their counter- parties to post collateral. As long as the value of collateral is higher than the value of the forward, no loss is incurred in case of default, and default risk is negligible.
Forward Contracts can broadly be classified as 'Fixed Date Forward Contracts' and 'Option Forward Contracts'. In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes place at a specified future date i.e. a fixed maturity date.
While forward contracts reflect both counterparty credit risk and market risk, futures contracts aim to eliminate counterparty risk to the extent possible, leaving only market risk.
The market value of a forward contract is a measure of the net amount one party owes the other. Only one party, the one owing the lesser amount, faces credit risk at any given time.
Why do people use forward contracts?
A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly useful for hedging. In forex markets, forwards are used to exploit arbitrage opportunities at the cost of carrying different currencies.
It basically describes how quickly something can be converted to cash. There are two different types of liquidity risk. The first is funding liquidity or cash flow risk, while the second is market liquidity risk, also referred to as asset/product risk.
The three main types are central bank liquidity, market liquidity and funding liquidity.
Liquidity Risk Indicators: Low levels of cash reserves, high dependency on short-term funding, or a high ratio of loans to deposits can hint at liquidity risk. Such indicators help banks ensure they can meet their financial obligations as they come due.
Market liquidity risk
When market liquidity begins to falter, financial markets experience less reliable pricing, and can tend to overreact. This has a knock-on effect, leading to an increase in market volatility and higher funding costs.
