Futures contracts and Forward contracts are forms of derivatives. In case you missed our previous post of derivatives, a derivative is contract between two or more parties with the value of the contract being tied to an underlying interest. An underlying interest can include stocks, bonds, commodities, currencies, interest rates, an index or the weather.
A futures contract is an agreement between two parties to buy or sell an underlying asset at a set price at a specific date in the future. These agreements are traded on an organized exchange and the exchange acts as a mediator and facilitator between the parties.
Futures trading is done through hedging or speculating. A hedger typically does not seek profit in a futures trade, but instead seeks to mitigate their risk and bring stability to the revenues or costs of their business.
Here’s an example of hedging in futures. A producer plans to grow 500 pounds of corn during the year. They could simply grow the corn and sell it for the current price at harvest time, or they can lock in a fixed price through a futures contract. Let’s say the producer locks in a price of $5 per pound for their corn. BY doing so they have removed the risk of corn prices dropping below $5 before harvest and guaranteed their amount of profit for their corn. However, they do take some risk that the price of corn could rise above $5 causing them to lose potential profit.
Someone speculating in futures contracts has no interest in owning the underlying asset. They don’t want to buy any corn, but instead guess the future price to make a profit. For example, if they expect corn prices to rise they could purchase a futures contract at $5 per pound. If the price does rise, say to $7 per pound, their futures contract is valuable and could be sold for a profit. By selling the futures contract that also negates them having to take possession of any corn.
Trading futures contracts relies on clearing members. They manage payments between a buyer and a seller. They guarantee each trade and to do so are typically large banks or financial services companies. To maintain the guarantee the clearing member requires traders to make a deposit known as margins. A margin is paid to ensure the trader has sufficient funds available and avoid anyone defaulting on the trade. The risk carried by clearing members leads to strict quality, quantity and delivery regulations on all futures contracts.
Like a futures contract, a forward contract is a contract between two parties to buy or sell an underlying asset for a set price on a specified future date. However, a forward contract is not traded on a central exchange and can be customized to any commodity, amount and delivery date. Since they are not traded on a centralized exchange they are referred to as over-the-counter. The lack of a central exchange also means they do not require a clearing house, which raises the risk of default.