Pros and Cons of Forward Contracts

The advantage of forward contracts is that they can be as flexible as the parties involved want them to be. This means that an institution like the First National Bank may be able to hedge completely the interest-rate risk for the exact security it is holding in its portfolio, just as it has in our example.

However, forward contracts suffer from two problems that severely limit their usefulness. The first is that it may be very hard for an institution like the First National Bank to find another party (called a counterparty)to make the contract with. There are brokers to facilitate the matching up of parties like the First National Bank with the Rock Solid Insurance Company, but there may be few institutions that want to engage in a forward contract specifically for the 6s of 2023. This means that it may prove impossible to find a counterparty when a financial institution like the First National Bank wants to make a specific type of forward contract. Furthermore, even if the First National Bank finds a counterparty, it may not get as high a price as it wants because there may not be anyone else to make the deal with. A serious problem for the market in interest-rate forward contracts, then, is that it may be difficult to make the financial transaction or that it will have to be made at a disadvantageous price; in the parlance of financial economists, this market suffers from a lack of liquidity. (Note that this use of the term liquidity when it is applied to a market is somewhat broader than its use when it is applied to an asset. For an asset, liquidity refers to the ease with which the asset can be turned into cash; for a market, liquidity refers to the ease of carrying out financial transactions.)

The second problem with forward contracts is that they are subject to default risk. Suppose that in one year's time, interest rates rise so that the price of the 6s of 2023 falls. The Rock Solid Insurance Company might then decide that it would like to default on the forward contract with the First National Bank, because it can now buy the bonds at a price lower than the agreed price in the forward contract. Or perhaps Rock Solid may not have been rock solid after all, and may have gone bust during the year, and no longer be available to complete the terms of the forward contract. Because there is no outside organization guaranteeing the contract, the only recourse is for the First National Bank to go to the courts to sue Rock Solid, but this process will be costly. Furthermore, if Rock Solid is already bankrupt, the First National Bank will suffer a loss; the bank can no longer sell the 6s of 2023 at the price it had agreed on with Rock Solid, but instead will have to sell at a price well below that, because the price of these bonds has fallen.

The presence of default risk in forward contracts means that parties to these contracts must check each other out to be sure that the counterparty is both financially sound and likely to be honest and live up to its contractual obligations. Because this type of investigation is costly and because all the adverse selection and moral hazard problems discussed in earlier chapters apply, default risk is a major barrier to the use of interest-rate forward contracts. When the default risk problem is combined with a lack of liquidity, we see that these contracts may be of limited usefulness to financial institutions. Although there is a market for interest-rate forward contracts, particularly in Treasury and mortgage-backed securities, it is not nearly as large as the financial futures market, to which we turn next.

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