Limitations of Forward Contracts

Forward markets are afflicted by several problems: (i) Lack of centralization of trading, (ii) Liquidation and (iii) Counterparts risk. The basic problem in the first two is that they have too much flexibility and generality. The forward market is like a real estate market in that any two consenting can form contracts against each other. This often makes them design terms of the deal that are convenient in that specific situation, but makes the contracts non tractable. Counterpart arises from the possibility of default by any one party to the transaction. When one of the sides to the transaction declares bankruptcy, the other suffers. Even when forward markets standardized contracts and, hence, avoid the problem of liquidity the counterparts risk remain very serious issue.

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