What Is Forward Trading?
In finance, forward trading may refer to two distinct activities. The first one involves an agreement between two or more parties to buy or sell a given amount of a specific asset on a future date and at a predetermined price. Assets like commodities, currencies and all types of securities are common in this type of transaction. The second type of forward trading is an illegal activity. In essence, this one involves brokers buying securities in advance when they know that the brokerage house will purchase a significant amount of the securities later, and thus benefit from a price appreciation.
Among various purposes, forward trading is one of the means through which corporations mitigate possible loss, an act known as hedging. During precarious economic times, for instance, currency rates may fluctuate widely, which can potentially harm the profits of businesses that operate on an international level. To lessen the impact of such wide currency rate fluctuations, international businesses may employ forward trading strategies. In so doing, they may enter into an agreement with a bank or other financial institution, and lock in a specific exchange rate.
To illustrate, consider a US-owned corporation that has operations in Europe, which is expecting to make payments or receive income denominated in Euros (EUR). Suppose with today's exchange rate, one would need $1.4 US Dollars (USD) to buy €1 EUR.For example, the US corporation might be expecting to receive €20,000,000 EUR, or $28,000,000 USD, in three months time. The corporation might have analysts who forecast that in three months it would require $1.3 USD to buy €1 EUR, which means they would receive $26,000,000 USD. Such an instance may require the corporation to engage in forward trading and lock in today's rate through an agreement, thereby removing the potential loss of $2,000,000 USD.
In practice, however, forward trading transactions are not that straightforward. One of the reasons is that it is extremely difficult to accurately forecast a particular currency exchange rate on a given future date. Moreover, when a company enters into a forward agreement, it surrenders all potential gains that might be received through a favorable move in exchange rates. At all events, when firms use forward agreements they still achieve the goal of removing the risk associated with wide currency rate fluctuations.
The illegal type of forward trading, also known as front running, involves brokers who use privileged information for their own personal gain. For example, a broker may learn that the brokerage house will purchase 500,000 shares of a particular stock. Before the brokerage house makes the purchase, however, the broker might go out and buy 500 shares of that stock. Such a move would mean that when the brokerage house buys the said amount of stocks, the stock price would rise. The broker would then make capital gains as he or she was able to buy the stock at a relatively lower price.
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