FUTURES CONTRACT - FORWARD CONTRACTS

 • A futures contract is a legal agreement to buy or sell a

particular commodity or asset at a predetermined price at a

specified time in the future.

• Futures contracts are standardized for quality and quantity to

facilitate trading on a futures exchange.

• A futures exchange is a diverse marketplace where

commodities ”futures”, ”index futures”, and ”options on

futures contracts “ are bought and sold.

• Those who are allowed access to the exchange are brokers and

commercial traders who are members of the exchange

• The buyer of a futures contract is taking on the obligation to buy

the underlying asset when the futures contract expires.

• The seller of the futures contract is taking on the obligation to

provide the underlying asset at the expiration date.

• First, futures contracts—also known as futures—

are marked-to-market daily, which means that daily

changes are settled day by day until the end of the

contract.

• Furthermore, a settlement for futures contracts can

occur over a range of dates.

• Because they are traded on an exchange, they

have clearing houses that guarantee the transactions.

• This drastically lowers the probability of default to

almost never.

• Contracts are available on stock exchange indexes,

commodities, and currencies. The most popular assets

for futures contracts include crops like wheat and corn,

and oil and gas

Features of futures contracts:

• Standardized contracts:

(1) underlying commodity or asset

(2) quantity

(3) maturity.

• Traded on exchanges.

• Guaranteed by the clearing house — little counterparty

risk.

• Gains/losses settled daily—marked to market.

• Margin account required as collateral to cover losses.

• The market for futures contracts is highly liquid, giving

investors the ability to enter and exit whenever they choose to

do so.

• These contracts are frequently used by speculators, who bet

on the direction in which an asset's price will move, they are

usually closed out prior to maturity and delivery usually never

happens. In this case, a cash settlement usually takes place.

• "Futures contract" and "futures" refer to the same thing.

What Happens if You Hold a Futures Contract Until Expiration?

• Oftentimes, traders who hold futures contracts until expiration will

settle their position in cash. In other words, the trader will simply pay

or receive a cash settlement depending on whether the underlying

asset increased or decreased during the investment holding period.

• In some cases, however, futures contracts will require physical

delivery. In this scenario, the investor holding the contract upon

expiration would be responsible for storing the goods and would need

to cover costs for material handling, physical storage, and insurance

Forward Contracts

• The forward contract is an agreement between a

buyer and seller to trade an asset at a future date.

• The price of the asset is set when the contract is

drawn up.

• Forward contracts have one settlement date—they all

settle at the end of the contract.

• These contracts are private agreements between two

parties, so they do not trade on an exchange. Because

of the nature of the contract, they are not as rigid in

their terms and conditions.

A forward contract is a customized contract between

two parties to buy or sell an asset at a specified price

on a future date.

• A forward contract can be used for hedging or

speculation, although its non-standardized nature

makes it particularly apt for hedging.

• Unlike standard futures contracts, a forward contract

can be customized to a commodity, amount

and delivery date. Commodities traded can be grains,

precious metals, natural gas, oil, or even poultry.

• A forward contract settlement can occur on a cash or

delivery basis

• Forward contracts do not trade on a centralized

exchange and are therefore regarded as over-thecounter

(OTC) instruments.

• While their OTC nature makes it easier to customize

terms, the lack of a centralized clearinghouse also

gives rise to a higher degree of default risk.

• As a result, forward contracts are not as easily

available to the retail investor as futures contracts

• A forward contract is a customizeable derivative

contract between two parties to buy or sell an asset

at a specified price on a future date.

• Forward contracts can be tailored to a specific

commodity, amount and delivery date.

• Forward contracts do not trade on a centralized

exchange and are considered over-the-counter (OTC)

instruments.

Example of a Forward Contract

• Consider the following example of a forward contract. Assume that an

agricultural producer has two million bushels of corn to sell six

months from now and is concerned about a potential decline in the

price of corn.

• It thus enters into a forward contract with its financial institution to

sell two million bushels of corn at a price of $4.30 per bushel in six

months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

1.It is exactly $4.30 per bushel. In this case, no monies are owed

by the producer or financial institution to each other and the

contract is closed.

2.It is higher than the contract price, say $5 per bushel. The

producer owes the institution $1.4 million, or the difference

between the current spot price and the contracted rate of $4.30.

3.It is lower than the contract price, say $3.50 per bushel. The

financial institution will pay the producer $1.6 million, or the

difference between the contracted rate of $4.30 and the current

spot price.

Risks of Forward Contracts

• The market for forward contracts is huge since many of the

world’s biggest corporations use it to hedge currency and interest

rate risks. However, since the details of forward contracts are

restricted to the buyer and seller—and are not known to the

general public—the size of this market is difficult to estimate.

• The large size and unregulated nature of the forward contracts

market mean that it may be susceptible to a cascading series

of defaults in the worst-case scenario. While banks and financial

corporations mitigate this risk by being very careful in their

choice of counterparty, the possibility of large-scale default does

exist.

• Another risk that arises from the non-standard nature of

forward contracts is that they are only settled on

the settlement date and are not marked-to-market like futures.

• What if the forward rate specified in the contract diverges

widely from the spot rate at the time of settlement?

• In this case, the financial institution that originated the

forward contract is exposed to a greater degree of risk in

the event of default or non-settlement by the client than if the

contract were marked-to-market regularly.

•Both forward and futures contracts involve the agreement

to buy or sell a commodity at a set price in the future.

•But there are slight differences between the two.

•While a forward contract does not trade on an exchange, a

futures contract does.

•Settlement for the forward contract takes place at the end

of the contract, while the futures contract settles on a

daily basis.

•Most importantly, futures contracts exist as standardized

contracts that are not customized between

counterparties.

Hedge

• A hedge is an investment to reduce the risk of adverse price

movements in an asset.

• The most common way of hedging in the investment world is

through derivatives.

• Derivatives are securities that move in correspondence to one or

more underlying assets.

• Derivatives can be effective hedges against their underlying

assets.

• The various kinds of options and futures contracts allow

investors to hedge against most any investment, including those

involving stocks, interest rates, currencies, commodities, and

more.

Hedging with Forwards and Futures

• Hedging with Forwards

• Hedging with forward contracts is simple, because one

can tailor the contract to match maturity and size of

position to be hedged.

Example. Suppose that you, the manager of an oil

exploration firm, have just struck oil. You expect that in 5

months time you will have 1 million barrels of oil. You are

unsure of the future price of oil and would like to hedge

your position. Using a forward contract, you could hedge

your position by selling forward 1 million barrels of oil.

Hedging with Futures

• One problem with using forwards to hedge is that

they are illiquid.

• Thus, if after 1 month you discover that there is no oil,

then you no longer need the forward contract. In fact,

holding just the forward contract you are now

exposed to the risk of oil-price changes.

• In this case, you would want to unwind your position

by buying back the contract. Given the illiquidity of

forward contracts, this may be difficult and expensive.

• To avoid problems with illiquid forward markets, one

may prefer to use futures contracts.