Fowards And Futures

Forwards

A forward contract is a private agreement between two parties giving the buyer an obligation to purchase an asset (and the seller an obligation to sell an asset) at a set price at a future point in time.

Binding contract under which a commodity or financial instrument is bought or sold at the market price (spot price) as on today (date of making the contract), but is to be delivered on a stated future (forward) date in settlement of the contract. In contrast, a futures contract is only a formal promise. Also called cash contract, cash forward contract, or cash forward sale.

The assets often traded in forward contracts include commodities like grain, precious metals, electricity, oil, beef, orange juice, and natural gas, but foreign currencies and financial instruments are also part of today's forward markets.

How it works/Example:

If you plan to grow 500 bushels of wheat next year, you could sell your wheat for whatever the price is when you harvest it, or you could lock in a price now by selling a forward contract that obligates you to sell 500 bushels of wheat to, say, Kellogg after the harvest for a fixed price. By locking in the price now, you eliminate the risk of falling wheat prices. On the other hand, if prices rise later, you will get only what your contract entitles you to.

If you are Kellogg, you might want to purchase a forward contract to lock in prices and control your costs. However, you might end up overpaying or (hopefully) underpaying for the wheat depending on the market price when you take delivery of the wheat.

A forward contract is traded in the over-the-counter (OTC) market, usually between two financial institutions or between a financial institution and one of its clients. However, this also means it is more difficult to reverse a position, as the counterparty must agree to cancel the contract. This also increases credit risk for both parties.

Forward contracts ability to lock in a purchase or sale price without incurring much direct cost makes it attractive for hedging as well as speculation.

Another example would help us to illustrate the mechanics of a forward contract. Suppose on January 1, 2012 an Indian textile exporter receives an order to supply his product to a big retail chain in the US. Spot price of INR/US exchange rate is Rs. 45/dollar.

After six months, the exporter will receive $1 million (Rs 4.5 crore) for his products. Since all his expenditure is in rupee term therefore he is exposed to currency risk. Let’s assume that his cost of production is Rs. 4 crore. To avoid uncertainty, the exporter enters into a six-month forward contract with a bank (with some fees) at Rs. 45 to a dollar. So the exporter is hedged completely.

If exchange rate appreciates to Rs. 35 after six months, then the exporter will receive Rs. 3.5 crore after converting his $1 million and the rest Rs. 1 crore will be provided by the bank. If exchange rate depreciates to Rs. 60/dollar then the exporter will receive Rs. 6 crore after conversion, but has to pay Rs. 1.5 crore to the bank. So no matter what the situation, the exporter will end up with Rs. 4.5 crore.

The only risk exporter faces is counterparty risk (what if the bank or the retail chain goes bankrupt).

Futures contract are very similar to forward contract except they are exchange traded, or defined on standardized assets. The futures markets are characterized by the ability to use very high leverage relative to the stock market.

Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of oil could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of oil by going long or short using futures. In reality, delivery of the underlying goods specified in futures contract is very low.

This is because the hedging or speculating benefits of the contracts can be had largely without holding the contract until expiry. For example, if you were long in a futures contract, you could go short on the same type of contract to offset and exit the position. This is similar to selling a stock you purchased in the equity market.

The mechanics of a futures contract is similar to forward contract described earlier. The only difference is that you can easily close your position anytime during the time of the contract.

Counterparty risk is also reduced, since both the parties have to provide margin to the exchange in which the trade has been done.

Forward Contracts are not the same as Futures Contracts

Futures and forwards both allow people to buy or sell an asset at a specific time at a given price, but forward contracts are not standardized or traded on an exchange. They are private agreements with terms that may vary from contract to contract.

Also, settlement occurs at the end of a forward contract. Futures contracts settle every day, meaning that both parties must have the money to ride the fluctuations in price over the life of the contract.

The parties to a forward contract tend to bear more credit risk than the parties to futures contracts because there is no clearinghouse involved that guarantees performance. Thus, there is always a chance that a party to a forward contract will default, and the harmed party's only recourse may be to sue. As a result, forward-contract prices often include premiums for the added credit risk.

Valuing Forward Contracts

The value of a forward contract usually changes when the value of the underlying asset changes. So if the contract requires the buyer to pay $1,000 for 500 bushels of wheat but the market price drops to $600 for 500 bushels of wheat, the contract is worth $400 to the seller (because he or she would get $400 more than the market price for his or her wheat). Forward contracts are a zero-sum game; that is, if one side makes a million dollars, the other side loses a million dollars.

Forward contracts may be "cash settled," meaning that they settle with a single payment for the value of the forward contract. For example, if the price of 500 bushels of wheat is $1,000 in the spot market (the current market price) when the forward contract expires, but the forward contract requires the buyer to pay only $800, then the seller can just settle the contract by paying the buyer $200 instead of actually delivering 500 bushels of wheat and collecting a below-market price. The buyer might appreciate this; the only other way he would see his $200 profit is if he purchased the wheat for $800

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