Forwards and futures have much in common. Both are present contracts that commit one party to deliver goods, currency, services etc. at a later date and the other to pay for the goods, services ... at that later date.
Today you and your spouse agree to sell your house to somebody at an agreed price when the school year is over.. Assuming this has all the elements of a contract, you have entered into a forward contract.
Suppose your company anticipates needing 400 million UK pounds six months from now. You, the CFO, are quite comfortable with the current exchange rate between dollars and pounds and you are even comfortable with the exchange rate expected to prevail six months from now by various experts in exchange rates.. What you are not comfortable with is the experts and their predictions. You know that there is some volatility in the foreign exchange markets and you feel that the potential change in these rates over the next six months adds an element of risk to your business that you would like to avoid. Accordingly you enter into a contract today with a financial institution (possibly a large local bank or possibly an English bank) to buy 400 million pounds from the instition six months hence at a price specified now, a price specified in US dollars. You have entered into a forward contract involving the price of English pounds (the "underlying") in terms of dollars for 400 million of those pounds (the "notional amount"). This contract is a forward contract and, like the contract on your house, is a derivative.
Your company, a large food processing company, will also be buying a large quantity of No. 2 Hard Red Winter wheat a few months after the harvest season and you and your purchasing agent worry about what the price of that wheat may be. If, for example, the intervening harvest is bad, the price of wheat may soar with detrimental effects on your company's income. You enter into futures contracts involving several million bushels of No. 2 Hard Red Winter wheat to be completed shortly after the time you will need the wheat. So far the forward contract for English pounds and the futures contract for wheat sound identical and certainly they have much in common. Both contracts are derivatives that contemplate a future transfer of something (a foreign currency, a commodity, etc.) in exchange for a payment at that later date.
There are, however, some important differences as you can see in Table 1. In a foward contract, for example, all the terms of the contract - price, quantity, dates, etc. - are set by the agreement between the contracting parties. Thus, farmer McDonald might agree to deliver 103,000 bushels of Grade A wheat to Archer Daniels Midland (ADM) between November 1 and November 10 at a price negotiated by the two parties. By contract, using futures contracts, if McDonald wishes to make arrangements now with regard to the 103,000 bushels he expects to harvest in November, he will find that all the terms of the futures, all but one, are set by the regulatory bodies and the exchanges on which these contracts trade. Since grain contracts are for 5,000 bushels he may enter into 20 such contracts for a total of 100,000 bushels, not exactly the 103,000 bushels he expects to harvest. In a forward contract between McDonald and ADM, the grain could be delivered to a grain elevator the parties found convenient whereas futures contracts will specify the delivery location such as Chicago or Kansas City. Grain futures usually have five delivery dates per year and McDonald's futures contracts may specify a December date rather than the November time frame when he is harvesting.
| Forward Contract | Futures Contract | |||||
|---|---|---|---|---|---|---|
| Contract terms | Parties negotiate price, quantity, quality and other terms | Exchanges and regulators set quantity, grade, delivery date etc. of basic contracts | ||||
| Number of parties | Maybe two - e.g. the farmer and Archer Daniels Midlands | Sellers, buyers, speculators, brokers, exchanges, clearing houses | ||||
| Typical Settlement | By performance | "Net" settlement | ||||
There is one term of the futures contract that is not set by the regulatory authorities and exchanges and that is the price. Various parties - farmers, food processors, speculators - buy and sell these standardized futures contracts and this market activity would set the price of December red. In contrast, in a forward contract between McDonald and ADM, the two parties would agree on the price although in their negotiations both would probably look carefully at the quoted futures prices in months near November.
Among the many differences between forwards and futures, one that deserves particular comment, is how the contracts are completed, settled or terminated. While forward contracts are usually settled by performance, it is rare for the parties to a futures contract to complete the contract by making delivery of the wheat, metal, etc. A forward contract might involve a deal between a US manufacturer and the Royal Bank of Canada (RBC) to buy a certain number of Canadian dollars at a later date; in most cases, when that date arrives, this being a forward contract, the US company will pay so many US dollars to RBC and RBC will "deliver" or credit the agreed number of Canadian dollars to an account for the US manufacturer.
By contrast, in a futures contract, it is rare for the "long" to expect to accept delivery and it is unusual for the "short" to plan to deliver. Both parties might terminate their positions by making contrary trades or "settle net." The buyer in the futures contract (the "long") might, at some later date, when the futures contract has fulfilled its purpose, make an offsetting sale and the clearinghouse will offset his purchase and his sale and his position has been closed. The original seller (the "short") may likewise decide that the arrangement has fulfilled her purpose and she may then make a purchase of the same futures contract; again, the exchange offsets her short and long positions and she too is out of the market. Depending on the type of futures contract, perhaps two to five percent are settled by delivery of the notional amount of the underlying.
In a forward contract, the parties may deal directly with each other: Old McDonald enters into a forward contract with ADM and the U.S. manufacturer deals with the Royal Bank of Canada. In a futures contract, by contrast, Madame Lazonga, whose tarot cards tell her that a terrible drought will cause the price of wheat to skyrocket in December, buys a December red contract and she does so without any contact with any of the farmers selling December red on the same date. In the unlikely event she decides to "perform" (unlikely because her garage isn't that big) the exchanges and clearing house will designate a counterparty to deliver the wheat. But even in this case involving performance, she does not deal directly with the counterparty. The counterparty delivers wheat to the warehouse and she gets wheat from the warehouse. Note that whether she "performs" (rare) or settles net (common), many parties (brokers, exchanges, clearing houses) in addition to the buyer (the "long") and seller (the "short") play a role.
Let's plug in some numbers and deal with a concrete example involving a speculation. Brian, on the basis of some thorough research (he has spoken to his astrologer, consulted the tea leaves and purchased a crystal ball) knows that the price of a particular commodity will increase considerably by December.
| DATE | SPOT PRICE | DEC.FUTURE PRICE |
| March 31 | $5 | $5.50 |
| December | ? | ? |
Here is his March 31 transaction. He buys 100 contracts of December futures at the futures price of $5.50 a bushel. Let's suppose the contract for this commodity is for 5,000 bushels so Brian is contracting to buy 500,000 bushels in December at $5.50 a bushel. He won't have to pay the $5.50 now; he is contracting to pay $5.50 a bushel in December. Yes, some money will trade hands now. He will have to pay commissions and other transaction costs. Also his broker and the exchange will want assurance that when December comes Brian can perform his part of the bargain; namely the brokerage firm will require Brian to post "margin" so they can be sure Brian can pay the $2,750,000 his contract implies. (The margin will, however, only be a part of the $2,750,000. The position can always be liquidated so that the exchange doesn't need to worry about the full $2,750,000, but only about the extent to which that number will fluctuate.) The futures market has a complicated system of initial margin, maintenance margin and variation margin that you will have to check out before you enter into a futures transaction. For simplicity, let's suppose he has lots of securities and funds on deposit with his broker so that no further margin need be posted.
Comes December and as the contract approaches expiration - OUCH! - the futures price and the spot price converge to $5.40. Brian had thought the price of a bushel would rise above $5.50 but it has fallen. The %#@ tea leaves were mistaken. Brian decides to tear up his futures contract and tells his broker not to bother getting the 500,000 bushels. His broker, however, reluctantly explains that a futures contract is not quite the same as, say, a call option. If you buy a call on some stock at $50 and the price of the stock drops to $45 as the option is about to expire, you just let your option expire worthless. The option gives the buyer the right but not the obligation to buy the stock at $50. By contrast, Brian must - unless he does something to settle that contract - pay $2,750,000 for 500,000 bushels of the commodity. If he goes through with the contract, he may then turn around and sell the commodity on the spot market for the prevailing price of $5.40 or a total of $2,700,000. Notice that Brian pays $2,750,000 for the 500,000 bushels and then sells it for $2,700,000. He has lost $50,000 on the transaction.
Will Brian actually accept delivery? Probably not. His broker informs him that he can get a warehouse receipt delivered to him within the next day or two and Brian takes a good look at his garage and basement and decides he doesn't want to go through with the deal. "What can I do?" he asks his broker. She explains that he can close his position by making an offsetting trade. He has bought December futures; he can now sell December futures for the same number of contracts of the same commodity and he is out of the market. Unfortunately, he is selling an obligation to buy the commodity at $5.50 and the commodity is only worth $5.40. To get out of the position he will have to pay the difference of $0.10 per bushel or $50,000. Anyway you look at it, Brian has lost $50,000.
What would Brian's profit have been if the astrologer had been correct and the December spot and futures price had converged to $6 a bushel? Ignore transaction costs.
Who was on the other side of Brian's deal? At the inception of a futures contract there is a counterparty. True, after the deal is made, the clearinghouse steps in between the two parties and is, in a sense, the counterparty for both the long (Brian) and the short. But even then there are as many contracts long as there are short and the clearinghouse is just a traffic cop between the longs and the shorts. There is still, in a sense, a counterparty to Brian's contract and the only problem is that Brian doesn't know the identity of that counterparty. (For that matter, he didn't know the identity of the counterparty when he made the original deal. It would have been handled for him by his broker and the exchange.)
Let's say the counterparty when Brian made his original deal was a merchant that had a large inventory of the commodity that it did not expect to sell until December. This counterparty, unacquainted with scientific decision theory, had not done the same market research as Brian and did not have any strong opinion about what the price would be in December. Furthermore, it didn't want to have to worry about what that price would be. It was satisfied with the $5.50 that some market participants forecasted would prevail in December. It wanted to "lock in" a price of $5.50 and it wanted to isolate itself from the risks involved in the fluctuations in that commodity's price. It didn't want its inventory to go down in value if the December price were lower than the March price and it was willing to forego any profit that would eventuate if the December price exceeded $5.50. Accordingly it sold 100 futures contracts of 5,000 bushels each for December delivery at $5.50.
When December arrives, the spot and futures prices for the commodity converge, as noted above, at $5.40. Does the company execute the futures contract, deliver the wheat to the Chicago warehouse specified in the futures contracts and collect the specified $5.50 per bushel? Chances are it does not. In all likelihood, it sells its 500,000 bushels in the normal channels it usually employs - Chicago may be an inconvenient delivery location - and gets only $2,700,000 (=$5.40 * 500,000 bu) for it. That's less, $50,000 less, than the $2,750,000 that market participants back in March were predicting would be realized in December. But offsetting this $50,000 loss is a $50,000 gain on the futures contracts. The company "settles net" at $0.50 a bushel since the original contracts provide for delivery at $5.50 when the prevailing price is only $5.40. Ignoring transaction costs, the mercant shuld receive $50,000 or $0.10 per bushel for 500,000 bushels. The company ends up with the same net effect as if it had been able to sell the commodity in December at the predicted $5.50.
In a sense, the futures market may be considered a "zero sum game." The $50,000 loss of Brian matches up with a $50,000 gain to the merchant. What one party loses, the other gains.
Notice a very significant difference between the speculator and the merchant. The speculator is entering a very risky market. Brian's loss was $50,000 and the gain, had the spot price been the $6 price he had predicted, would have been $250,000. Those are substantial losses and gains when you bear in mind that the initial contract, ignoring transaction costs and margin, involved no outlay by Brian. If we measure risk by how much the outcomes may differ from the initial cash payment, futures markets (and derivatives in general) tend to be very risky for the speculator.
By contrast, the merchant, instead of increasing exposure to risk by entering into a futures contract, is reducing it. He is "hedging" his bets and reducing his risks. The merchant will not be hurt by a "bad" outcome (a lower price in December) and, on the other hand, will not benefit from a "good" outcome (a higher price).
While forward and futures markets involve many aspects not covered here, you have an idea of their basic futures. You might move on now to look at swaps or to delve more deeply into the nature of the players and their purposes.
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