Solutions (Risk ) - Dealing with Forward Transaction problems

Just as there is Direct and Indirect lending to deal with lending problems, there are the Futures market and Forward intermediaries, respectively, to deal with problems of forward transactions.

Futures market - Its the analog of the stock exchange. Suppose that I am selling copper to a client company as a forward transaction. Instead what I could do is go to the futures market and sell copper futures to traders there. Each contract commits you to deliver certain amount of copper at a certain time at a decided price. The price would be determined by supply and demand. The distinct advantages are -
1) Both parties are guaranteed against default. If I am not able to deliver copper, the exchange will provide the buyer with copper at the previously agreed price. If the buyer fails to keep his part of the promise, the exchange will buy from me at the agreed price.
2) Its a place to find a huge pool of buyers and traders. The contracts are standardized to increase the no of potential traders ( standard amount of standard grade to be delivered at standard time ). Thus you get a fair price and transaction costs are low.
3) Liquidity problem is solved. Suppose that you know beforehand that you are not going to be able to supply the promised copper. All you do is ask the exchange to buy you the same no. of copper futures as the ones you have sold. Since you will now be obliged to deliver and accept tht much copper at the stipulated time, it gets nullified.

Note that futures trading exists for metals, agricultural commodities, oil, etc.



Forward Intermediaries - Forward intermediaries act as intermediates between two parties involved in frwd transaction. Suppose party A ( Japanese ) owes party B ( Indian ) 100000 Rs after buying 100000 Rs worth of exports from B. A sells off these exports in Japan, expecting to make a certain profit after paying off B after, say, one year. However, A notices that the Yen has fallen w.r.t. the Rupee such that 100000 Rs in now worth much more Yen. Thus, A is now facing a loss because of exchange rate variation. Here, a bank, which buys and sells exchange rate forward can help A. A will buy 100000 Rs forward ( to be given to it after 4 months ) at the current exchange rate and will pay off B with these, thus being in profit as per its calculations. Its is like locking a price. Doesn;t this pass on the risk to the bank?? Answer is NO. Because the Bank has people interested in selling Yen forward as well (those who expect Yen to rise against Rupee). These two cases offset the bank's risk. Main advantage here is lowering of transaction costs and surety factor of the bank. The bank is able to offer liquidity because of pooling. Also, it is well equipped to assess all credit standings and choose customers wisely.