Liquidity Risk of a Forward Contract
A forward contract is an arrangement between two parties that one will sell the other an asset at a fixed price on a future date. This fixed price applies regardless of the actual market price of the asset at the time. The difference between the fixed price and the market price will determine who comes out best on the deal. People may engage in a forward contract to speculate, hedge against a larger deal or increase certainty about future costs or revenues.
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Forward vs Futures
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A forward contract has the same basic contract as a futures contract. The main difference is that a forward contract is a private arrangement, while a futures contract is conducted via a regulated financial exchange. Usually a futures contract is conducted under fixed terms and conditions, while a forward contract is more open to negotiation.
Liquidity Risk: Non-Payment
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Somebody with a futures contract can be reasonably confident of having control of liquidity, knowing when he will have to make the payment or will receive the cash, and knowing the amount of the transaction. With an unregulated forward contract there is a greater chance that one party either won't or can't complete the exchange, meaning the only way to force the deal will be to take legal action. This not only limits liquidity, but may make things worse in the short term, as it entails legal expenses.
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Liquidity Risk: Seller
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The party agreeing to sell an asset often does not own the asset at the time the deal is made. She will instead plan to buy it just before the exchange, hoping the price has dropped in the meantime so she can make an immediate profit. This is a liquidity risk because the seller does not know how much cash she will need when she buys the asset.
Liquidity Risk: Selling a Position
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It is possible for one or even both parties in a forward or futures contract to sell the rights to their part in the deal, known as a position, to a third party before the agreed completion date. Indeed, some investors intentionally buy positions in such contracts with the aim of selling them at a profit rather than completing the exchange. Because forward contracts are not traded on regulated markets, it is likely traders will find it harder to find a buyer for a position, or may be less likely to get a good price. This creates liquidity risk, as the trader will have much less confidence about being able to sell the position and raise cash if needed.
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