In forward and futures contracts, two or more parties agree to buy or sell a specific asset at a predetermined price by a given date in the future. By securing the buy or sell price in advance, buyers and sellers can reduce the risks brought on by future price changes.
An over-the-counter (OTC) agreement known as a forward contract settles just once at the end of the contract period. Both parties negotiate the specific conditions of the agreement. Since the counterparty is in charge of remitting payment, it is a privately negotiated agreement that carries some default risk.
On the other hand, futures contracts are standardized contracts traded on stock exchanges. As a result, they are settled every day. These agreements have standard terms and defined maturity dates. Futures guarantee payment on the specified date. Thus there is minimal risk involved.
What Are Forwards?
In a forward contract, the buyer and seller have mutually agreed to swap the underlying asset for cash at a specific future date and at a specific price.
The forward contract states the asset’s quality, quantity, rate, and settlement date. Such contracts are traded in the Over the Counter (OTC) market, which is decentralized and allows the modification of contract terms to meet the interest of the parties involved.
In a forward contract, the buyer is referred to as being long, and his position is expected to be long. The seller is referred to as being short and maintaining a temporary position. The buyer makes money when the value of the underlying asset increases and exceeds the agreed-upon price. However, if prices decline and are below the agreed-upon price, the seller is still successful.
How Do Forward Contracts Work?
In the financial markets, forward contracts are agreements between the seller and the buyer of a commodity.
A forward contract specifies the commodity being sold, the quantity the buyer is willing to buy, the commodity’s current price, and the contract’s expiration date. The seller and buyer are not required to exchange money if the commodity’s price has not changed by the contract’s settlement date.
The financial institution will receive or pay the value difference if the forward price differs from the spot price at the contract’s settlement date. The seller owes the buyer the difference between the spot price and the future price if the commodity’s forward rate has increased. The buyer owes the seller the difference if the delivery price has decreased.
What Are Futures?
The agreement to buy and sell an item at a certain price at a future date is a component of futures contracts, similar to forwards contracts.
However, there are some differences. Since these contracts are marked-to-market (MTM) daily, daily adjustments are settled one day at a time until the contract’s expiration date. Due to the futures market’s high level of liquidity, investors can enter and exit any time. These contracts are usually used by speculators who bet on which direction the price of an asset will move. They are typically closed out before maturity, and delivery rarely occurs. In this situation, a cash settlement is typical.
They have clearing houses that guarantee transactions since they are traded on an exchange. This reduces the likelihood of default to almost zero.
Contracts on stock market indices, commodities, and currencies are all accessible. Commodities such as wheat and corn and oil and gas are among the most popular assets for futures contracts.
How Do Futures Contracts Work?
Hedging and Speculating are the two ways, Futures traders might approach Futures contracts.
Hedging
Hedgers use futures contracts as protection against changes in an underlying asset’s price. The hedger effectively guarantees the current market price by entering into a futures contract in order to prevent a damaging loss if the asset price moves negatively.
For instance, the price of oil fluctuates constantly. If an oil business believes the current market price of oil is greater than when their customer would want to buy it in the future, they might agree to a futures contract. A buyer of oil who is concerned that the price will increase in the future can try to lock in the current price with a futures contract so they won’t have to be concerned about negative market volatility.
Speculating
Using futures contracts, speculators can make a profit by taking a long or short position on the price of an asset in the future.
For instance, a traded who anticipates that gold’s current price will rise sharply can buy gold futures at a discount, then resell the contracts for a profit at a higher price. Or, if the trader believes that the price of gold is artificially inflated, they might short sell gold futures, watch for a price drop, and then repurchase the futures contracts at the new, lower price. Speculation is a high-risk, short-term trading method where speculators make educated guesses.
Forwards VS Futures
The following are the key differences between forwards and futures contracts.
- A forward contract is an agreement between parties to buy and sell the underlying asset at a specific price on a future date. On the other hand, a futures contract is a binding agreement between two parties to buy or sell an asset at a specific price and time.
- Buyer and seller agree on the conditions of a forward contract. As a result, it can be adjusted. In contrast, a futures contract is standardized since it specifies the amount, delivery date, and other terms in advance.
- Since there is no secondary market for such contracts, forwards are traded over the counter (OTC). The trading of futures contracts, on the other hand, takes place on a regulated securities exchange.
- Forward contracts settle on a maturity date when it comes to settlement. In contrast to futures contracts, which are daily marked to market (MTM), profits and losses are paid daily.
Takeaways
- The forward contract states the asset’s quality, quantity, rate, and settlement date.
- Forward contracts are agreements between the seller and the buyer of a commodity.
- The agreement to buy and sell an item at a certain price at a future date is a component of futures contracts.
- Hedging and Speculating are the two ways Futures traders might approach Futures contracts.
