DEFINITION of Forward Margin
The forward margin reflects the difference between the spot rate and the forward rate for a certain commodity or currency. The difference between the two rates can either be a premium or a discount, depending if the forward rate is above or below the spot rate, respectively. If you add or subtract the forward margin to the spot rate, you would get the forward rate.
BREAKING DOWN Forward Margin
A forward margin is an important concept in understanding forwards markets, which are over-the-counter or OTC marketplaces that set the price of a financial instrument or asset for future delivery. Forward markets are used for trading a range of instruments, including the foreign exchange market, securities and interest rates markets, and commodities.
Foreign exchange markets are global exchanges (notable centers in London, New York, Singapore, Tokyo, Frankfurt, Hong Kong and Sydney), where currencies are traded virtually around the clock. These are large and highly active traded financial markets around the world, with an average daily traded volume of $1.805 trillion in 2018. Institutional investors such as banks, multinational corporations, hedge funds and even central banks are active participants in these markets.
Similar to foreign exchange markets, commodities markets attract (and are only accessible to) certain investors, who are highly knowledgeable in the space. Commodities markets can be physical or virtual for raw or primary products. Major commodities by liquidity include crude oil, natural gas, heating oil, sugar, RBOB gasoline, gold, wheat, soybeans, copper, soybean oil, silver, cotton, and cocoa. Investment analysts spend a great deal of time speaking with producers, understanding global macro trends for supply and demand for these products around the world, and even take into account the political climate to assess what their prices will be in the future.
Standardized forward contracts are also referred to as futures contracts. While forward contracts are private agreements between two parties and carry a high counterparty risk, futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default.
Forward Margin and Spot Rate
As mentioned above, the spot rate differs from the forward rate by the forward margin. The spot rate, also called spot price, is the price quoted for immediate settlement on a commodity, security or a currency. It is the market value of an asset at the moment of the quote. As a result of constantly fluctuating demand, spot rates change frequently and sometimes dramatically.