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What Are Forward and Futures Contracts?

What Are Forward and Futures Contracts?

Significantly, forward and futures contracts involve an agreement to buy and sell assets at a future date. Both contracts fundamentally share the same function, however, the definite details of each are different.

Forward Contracts

A forward contract is a private agreement that settles at the end of the agreement, at a future date. The price of the asset is set when the contract is drawn up. Since these contracts are handled privately between two parties, they do not trade on an exchange. As it is the nature of the contract, they are not as rigid in their terms and conditions.

Verily, many hedgers use forward contracts to cut down on the volatility of an asset’s price. Since the terms of an agreement are set when the contract is executed, a forward contract is not subject to price fluctuations.

However, forward contracts are not readily available to retail investors as the market is often hard to predict. That is because the agreements and their details are generally kept between the buyer and seller, and are not made public. Since they are private agreements, there is high counterparty risk. This means there may be a chance that one party will be a default.

Futures Contracts

Like forward contracts, futures contracts involve the agreement to buy and sell at a specific date at a future date. A futures contract, also known as futures, is traded on an exchange and is settled daily until the end of the contract. This way, a settlement for futures contracts can occur over a range of dates. The futures contract, however, slightly differs from the forward contract.

Because they are traded on an exchange, they have Clearing House that guarantees the transactions. This drastically reduces the probability of default. Contracts are available on stock exchange indexes, commodities, and cryptocurrencies.

The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so. Particularly, these contracts are frequently used by speculators, who bet on the direction in which an asset’s price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

Within the financial industry, futures contracts typically offer the following functions:

  • Hedging and risk management: futures contracts can be utilized to mitigate against a specific risk.
  • Leverage: futures contracts allow investors to create leveraged positions. As contracts are settled at the expiration date, investors can leverage their position.
  • Short exposure: futures contracts allow investors to take a short exposure to an asset. When an investor decides to sell futures contracts without owning the underlying asset, it is commonly referred to as a “naked position”.
  • Asset variety: investors can take exposure to assets that are difficult to be traded on the spot.
  • Price discovery: futures markets are a one-stop-shop for sellers and buyers (i.e. supply and demand meet) for several asset classes, such as commodities.

Settlement Mechanism

When a futures trader takes a position (long or short) in a futures contract, he can settle the contract in three ways:

  • Physical Delivery: the underlying asset is exchanged between the two parties that agreed on a contract at a predefined price. The party that was short (sold) has the obligation to deliver the asset to the party that was long (bought).
  • Cash Settlement: in this case, and in case the contract has expired, there is no need for physical delivery of the contract. Instead, the contract can be cash-settled. Cash-settled futures contracts are more convenient and, therefore, more popular than physical-settled contracts, even for liquid financial securities or fixed-income instruments whose ownership can be transferred instantly.

Exit Strategies for Futures Contracts

There are three movements that futures traders can perform:

  • Offsetting: refers to the act of closing a futures contract position by creating an opposite transaction of the same value. So, if a trader is short 50 futures contracts, they can open a long position of equal size, neutralizing their initial position. The offsetting strategy allows traders to realize their profits or losses prior to the settlement date.
  • Rollover: occurs when a trader decides to open a new futures contract position after offsetting their initial one, essentially extending the expiration date.
  • Settlement: if a futures trader does not offset or rollover their position, the contract will be settled at the expiration date. At this point, the involved parties are legally obligated to exchange their assets (or cash) according to their position.

Futures Contracts Price Pattern

From the moment futures contracts are created until their settlement, the contracts market price will be constantly changing as a response to buying and selling forces.

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The relation between the maturity and varying prices of the futures contracts generate different price patterns, which are commonly referred to as contango (1) and normal backwardation (3). These price patterns are directly related to the expected spot price (2) of an asset at the expiration date (4), as illustrated below.

Contango (1): a market condition where the price of a futures contract is higher than the expected future spot price.

Expected spot price (2): anticipated asset price at the moment of settlement (expiration date). Note that the expected spot price is not always constant, i.e., it may change in response to market supply and demand.

Normal backwardation (3): a market condition where the price of futures contracts is lower than the expected future spot price.

Expiration date (4): the last day of trading activities for a particular futures contract, before settlement occurs.

While contango market conditions tend to be more favourable for sellers (short positions) than buyers (long positions), normal backwardation markets are usually more beneficial for buyers. As it gets closer to the expiration date, the futures contract’s price is expected to gradually converge to the spot price until they eventually have the same value. If the futures contract and spot price are not the same at the expiration date, traders will be able to make quick profits from arbitrage opportunities.

In a contango scenario, futures contracts are traded above the expected spot price, usually for convenience reasons. For instance, a futures trader may decide to pay a premium for physical commodities that will be delivered in a future date, so they don’t need to worry about paying for expenses such as storage and insurance (e.g. gold). Additionally, companies may use futures contracts to lock their future expenses on predictable values, buying commodities that are indispensable for their service (e.g., bread producer buying wheat futures contracts).

On the other hand, a normal backwardation market takes place when futures contracts are traded below the expected spot price. Speculators buy futures contracts hoping to make a profit if the price goes up as expected. For example, a futures trader may buy oil barrels contracts for $30 each today, while the expected spot price is $45 for the next year.

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