What Is Forward Margin?
The forward margin, or forward spread, 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 on if the forward rate is above or below the spot rate, respectively.
- The forward margin is the difference between the forward rate less the spot rate, or, in the event of a discount rate, the spot rate minus the forward rate.
- The forward margin can be large, small, negative, or positive, and represent the costs associated with locking in the price for a future date.
- The forward margin will be different based on how far out the delivery date of the forward is as a one year forward will be priced differently than a 30-day forward.
- The forward margin is often measured in basis points, known as forward points, and if you add or subtract the forward margin to the spot rate, you would get the forward rate.
Understanding Forward Margin
The forward margin is an important concept in understanding the functioning of forwards markets, which are over-the-counter (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.
The forward margin gives traders some indication of supply and demand over time of the underlying asset that the forward is based on. The wider the spread, the more valuable the underlying asset is perceived to be in the future. Meanwhile, the smaller margins indicate that the underlying asset is likely to be more valuable now than in the future. The forward margin is often measured in basis points, known as forward points, and if you add or subtract the forward margin to the spot rate, you would get the forward rate.
Narrow, or even negative margins, might result from short-term shortages, either real or perceived, in the underlying asset. With currency forwards, negative margins (called discount spreads) occur frequently because currencies have interest rates attached to them which will affect their future value.
There is also an element of carrying cost. Owning the asset now suggests that there are costs associated with keeping it. For commodities, that can be storage, insurance, and financing. For financial instruments, it could be financing and the opportunity costs of locking into a future commitment.
Carrying costs may change over time. While storage costs in a warehouse may increase, interest rates to finance the underlying may increase or decrease. In other words, traders must monitor these costs over time to be sure their holdings are priced properly.
Remember, 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.
Forward Margins & Forwards Markets
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 $6.6 trillion in early 2019. 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.