Forward and Futures Contracts

Part 1: Forward Contracts

A forward contract is a private contract between a buyer and a seller in which the buyer agrees to buy and the seller agrees to sell a specific quantity of a certain security or commodity (known as the underlying instrument) at the price specified in the contract. The difference between a forward contract and most other sales contracts is that with the forward contract, the delivery and payment of the underlying instrument occurs at a specified future date instead of immediately. Let’s take a look at an example. 

Before a wheat farmer plants his crop, he executes a contract with a cereal company for the delivery and purchase of 75,000 bushels of wheat at a price of $1 per bushel. The actual exchange of the wheat for money will, of course, not take place until after the crop is harvested in the fall. By entering into a forward contract, both the farmer and the cereal company reduce their respective risks. By pre-selling his crop at $1 per bushel, the farmer has protected himself against the risk that in the fall the then-current price (or spot price) will be lower than $1 per bushel. The cereal company, on the other hand, by pre-purchasing has protected itself against the risk that in the fall the spot price of wheat will be greater than $1 per bushel. Both parties to the transaction sacrifice the possibility of getting a better price for themselves in exchange for eliminating the risk of getting a worse price.
When harvest time arrives, the spot price will either be higher or lower than $1 per bushel depending on the normal circumstances that affect supply and demand. If the price at harvest has risen to, say $1.35 a bushel, the farmer will undoubtedly wish that he had not entered into the forward contract. The cereal company, however, will be quite pleased to pay a below-market price of $1 per bushel. On the other hand, if the spot price in the fall drops to $0.75 per bushel, the farmer will be delighted to be getting the above-market price of $1. The cereal company, of course, will not be so thrilled to have to pay $1 per bushel when the market rate is $0.75. In this contract, as with all forward contracts, the buyer is pleased if the agreed-upon contract price is lower than the spot price and the seller is happy if the contract price is higher than the spot price.
Because the forward contract is privately executed between the two entities, the primary goal when entering into it should be to ensure that all of the terms and contingencies are clear and that there are no uncertainties or ambiguities. Some contract parameters which should be clearly defined include: delivery terms and location, quality specifications of the underlying instrument, payment and credit terms (both parties are exposed to the risk of the other defaulting on its obligation), a dispute resolution procedure, cancellation provisions (the vast majority of forward contracts do not have such provisions), liquidity, and price transparency (which is the widespread availability of timely and accurate price information to any interested parties). 

Part 2: Futures Contracts

The first article of this series illustrated the basics of forward contracts. In this article we will discuss futures contracts and the differences between the two.  

A futures contract, unlike the privately-traded forward contract, is publicly traded. As with the forward, each futures contract is for the purchase or sale of a loan, currency or commodity with actual delivery scheduled to occur at some time in the future. While the concept behind both forwards and futures contracts is the same -- namely, providing a way for buyers and sellers to lock in a price today for transactions that will take place in the future -- the way in which they are implemented is, for the most part, completely opposite.
While forward contracts are privately executed between two parties who know each other (at least figuratively speaking), futures contracts trade on the floor of a futures exchange. And because they trade on the floor of an exchange, the transactions are always handled by brokers who are members of that exchange. No futures contracts are executed by the parties themselves, thereby maintaining anonymity throughout the process. For example when someone buys pork bellies or U.S. T-bills via a futures contract, they have no idea whom they are actually buying them from, which brings up the subject of risk.
The only reason that people are willing to buy and sell futures contracts with anonymous counter parties is that the exchange which facilitates the transaction guarantees all trades. So, unlike forward contracts, where each side is exposed to the credit risk of its counter party, with futures, the exchange assumes the credit risk if a party defaults on its obligations. The exchanges are, in turn, backed by insurance policies, lines of credit, and the financial strength of their members. This makes them, for all intents and purposes, free of any credit risk. The exchanges significantly reduce the amount of risk to which they themselves are exposed by setting forth strict rules concerning the counter parties and contracts in which they deal. For example, customers who buy and sell futures contracts are required to post a security deposit, known as a margin, against their market position. They are also required to cover their losses on a daily basis, which is commonly referred to as being “marked to the market”. Additionally, exchanges demand that delivery of the underlying instrument at the expiration of the contract be done at the then current spot price.
The fact that delivery occurs at the spot price has two very important effects on the futures market: first, it removes any incentive for either party to default on the contract when the time for delivery arrives. The spot price and the price that the exchange pays are the same, so neither buyer nor seller can gain an advantage by dealing with a source other than the exchange (which would raise further credit risks for the parties anyway). It also removes any incentive for either party to actually go through with the delivery procedure. (One of the major advantages of futures is that neither side has to hold onto its position until contract expiration.) Because all profits and losses associated with the transaction are already recorded in each party’s margin account (remember that they’re “marked to the market”), most futures contracts are closed out in advance. Only a very small percentage of them ever actually go to delivery.