A forward contract is basically entered into by two parties to
exchange a pre decided sum of money or an underlying asset on a
predecided date in the future. No amount of money exchanges hands
at the time of getting into the contract, but the contract is an
obligation on both the parties unlike in the case of another
derivative instrument called options. A Forward is similar to
Future in some respects but different in other respects as
explained in the below points, but essentially they are obligatory
to both parties and have similar nature of contract.
- Marked to market: This is false and is one of
the reasons why the default risk is high for the forward contracts.
Marking to market is the process of netting each day's profits and
losses to bring down the stakes so that in case of default, the
expected loss is low. This feature more aking to Futures contract
and not Forward Contracts
- has significant default risk: This is true for
Forward contracts due to the lack of a clearing house in between
which becomes the counterparty in each contract. Clearing house
feature is available in Futures contract. Clearing house is
basically an exchange, which guarantees that the contract will be
met.
- is standardized: This is false, one of the
reasons why forward contracts are popular is because they are
tailor made, suiting to the needs of the parties getting into them
and therefore it is harder to find a suitable
counterparty.Standardisation feature is more aking to Futures
contract and not Forward Contracts
- is traded over the counter: As mentioned
earlier, there is no clearinghouse or an exchange which is the
counterparty as in case of Futures contract and further the
contracts are customized having high default risk. All these point
us to the fact that Forward contracts are traded over the counter,
so this is true
- is highly liquid: As explained in the above
points, it is difficult to find a suitable counterparty to these
contracts due to the customization they undergo, this makes them
less liquid. Further due to being traded OTC and not on an
exchange, these have lower liquidity. So this point is false