Futures and Forwards contracts are an example of equity derivative which derives their value from the performance of underlying assets. These underlying assets can be stocks, indexes, currency, commodities, or interest rates. The two most popular uses of Future and Forward contracts are- Hedging and Speculation. Having said this, hedging involves offsetting or safeguarding your risk against uncertainties of the market. And hedging position is the opposite of a position that one already has in the spot market.
On the other hand, speculation involves speculators having enough knowledge about the market. They can predict market movements and take the market position accordingly. If the price of a security hikes, they take a long position making gains from their forecast and vice-versa.
Both futures and forwards are contracts that allow the investor to buy or sell an asset at a specified time and price. Though they look alike but have a narrow difference. Which as follows:
A forward contract, a private agreement, enables the buyer and the seller to exchange an asset for cash at a predetermined future date at a quoted price of the day when the agreement is made. Forwards trades on the over-the-counter exchange market, and the transfer of ownership occurs on the spot. However, the delivery of the asset takes place only on the specified date. Furthermore, forwards works in accordance with the needs of counterparties, enabling customization of contract such as the delivery date and so on.
Suppose, on December 21, 2016, a refiner enters into an agreement with a crude oil supplier to buy 1 million barrels in 3 months’ time at the rate of USD 60/barrel. What is the cash flow consequence on the delivery date for the refiner and the supplier if the spot rate/future rate of crude oil is USD 75?
Explanation: If the spot rate is USD 75 a barrel, then the refiner is obliged to buy from the supplier 1 million barrels at USD 60 a barrel. Indeed, the refiner will pay the supplier USD 60 million and, in exchange, will get 1 million barrels of crude oil. Here the refiner is benefitted; if he is to buy the same 1 million barrels in the spot market, he might have to pay USD 75 million. Therefore his gain is USD 15 million.
Problem with Forward Contracts
The forward contracts lack centralization of trading. They are considerably illiquid in nature and involve counterparty risk. The counterparty risk is one of the major problems of forward contracts. The risks arise when one of the two parties involved in the transaction goes bankrupt—for instance, failure on the tin forward market at the London Metal Exchange.
A futures contract, a standardized exchange-traded forward contract, trades as per the rules and regulations. Future Contract is traded on the secondary market and enables trading of the whole contract and not fractional contracts. A futures contract is an agreement between buyer and seller to trade a commodity or any financial instrument at a future date for a price agreed at the time the contract is drawn up. The future contract exchange acts as a clearinghouse, ensuring the elimination of default risk. To protect from the default risk, the clearinghouse requires the participants to keep the margin money. Ranging from 5% to 10% of the face value of the contract.
If an investor purchased a single future contract in June, says ABC Ltd, he has to buy it at a price prevailing in the market. Let’s say these futures are trading at $80 per share. This implies that the investor agreed to buy/sell at a fixed price of $80 per share on June last Thursday. However, it is not necessary that the price in the spot market must be $80 on the expiry. Depending on the prevailing market conditions, it could be $77 or $82 or anything else. This difference leads to gain or loss.
Uses of Forward and Futures
As mentioned earlier, Hedging means to safeguard the risk and to explain the concept of hedging; let’s take an example: Suppose a wheat farmer enters into a forward/future contract selling his harvest at a known price to eliminate the default price risk. On the contrary, a bread factory may want to buy wheat forward/future to assist production planning without the risk of price fluctuation.
If a speculator forecasts a hike in prices, he might go long on the forward/future market instead of the cash market. He would wait for the price to rise and then take a reversing transaction. Speculator gets the benefit of leverage by using forwards and future.
Price discovery is one of the most powerful uses of forwards and futures contracts; it helps market prices to predict the spot price that might prevail in the future. These predictions are quite useful in production decisions.
Further, Forwards and futures protect the risk associated with the foreign exchange rate and share price, interest rate and commodity price fluctuation, etc.
To summarize, both forwards and futures contracts entail buying and selling a commodity or financial instrument at a specific time and price. Futures contracts are standardized contracts traded on an exchange. Whereas forwards private bilateral contracts between two parties, agreeing to exchange a commodity or asset at a specified future price. In forward contracts, there is always a risk of default. On the contrary, future contracts have a clearinghouse that guarantees the transaction and eliminates the default risk—settlement of the forward contract end at the specified date. Further, futures contracts trades marked to market daily, stating the determination of daily value until the expiry of the contract (last Thursday of every month). Hedgers use forwards to eliminate the volatility in the prices of assets, whereas use futures.