Limitations of Forward Markets

LIMITATIONS OF FORWARD MARKETS

Forward Markets world-wide are afflicted by several problems like LACK OF CENTRALIZATION OF TRADING, LIQUIDITY and COUNTER PARTY RISK.

 

In the first two of these, the basic probk much flexibility and generality. The forwc. estate market in that any two consenting aa contracts against each other. This often 1. design terms of the deal which are very conven specific situation, but makes the contracts non. Counter party risks arises from the possibility of c by any one party to the transaction. When one of the sides to the transaction declares bankruptcy, the ot. suffers. Even when forward markets trade standardize contracts, ad hence avoid the problem of illiquidity, still counter party risk remains a very serious issue.

INTRODUCTION TO FUTURES

Futures markets were designed to solve the problems that exist in forward markets. A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a certain price. But unlike forward contracts, the futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. More than 99% of futures transactions are offset this way. The standardized items in a futures contract are

  1. QUANTITY OF THE UNDERLYING
  2. QUALITY OF THE UNDERLYING
  3. THE DATE & MONTH OF DELIVERY
  4. THE UNITS OF PRICE QUOTATION AND MINIMUM PRICE CHANGE.
  5. LOCATION OF SETTLEMENT.

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