forwards vs futures in commodity market

8/11/2019 Forwards vs Futures in Commodity Market

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Forward Contracts

A forward is an agreement between two counterparties - a buyer and seller. The

buyer agrees to buy an underlying asset from the other party (the seller). The

delivery of the asset occurs at a later time, but the price is determined at the time

of purchase. Key features of forward contracts are:

Highly customized - Counterparties can determine and define the terms

and features to fit their specific needs, including when delivery will take

place and the exact identity of the underlying asset.

All parties are exposed to counterparty default risk - This is the risk that the

other party may not make the required delivery or payment.

Transactions take place in large, private and largely unregulated markets

consisting of banks, investment banks, government and corporations.

Underlying assets can be stocks, bonds, foreign currencies, commodities

or some combination thereof. The underlying asset could even be interest

rates.

They tend to be held to maturity and have little or no market liquidity.

Any commitment between two parties to trade an asset in the future is a

forward contract.

Example: Forward Contracts

Let's assume that you have just taken up sailing and like it so well that you

expect you might buy your own sailboat in 12 months. Your sailing buddy, John,

owns a sailboat but expects to upgrade to a newer, larger model in 12 months.

You and John could enter into a forward contract in which you agree to buy

John's boat for $150,000 and he agrees to sell it to you in 12 months for that

price. In this scenario, as the buyer, you have entered a long forward contract.

Conversely, John, the seller will have the short forward contract. At the end of

one year, you find that the current market valuation of John's sailboat is

$165,000. Because John is obliged to sell his boat to you for only $150,000, you

will have effectively made a profit of $15,000. (You can buy the boat from John

for $150,000 and immediately sell it for $165,000.) John, unfortunately, has lost

$15,000 in potential proceeds from the transaction.


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Like all forward contracts, in this example, no money exchanged hands when the

contract was negotiated and the initial value of the contract was zero.

Futures Contract

Future contracts are also agreements between two parties in which the buyer

agrees to buy an underlying asset from the other party (the seller). The delivery

of the asset occurs at a later time, but the price is determined at the time of

purchase.

Terms and conditions are standardized.

Trading takes place on a formal exchange wherein the exchange provides

a place to engage in these transactions and sets a mechanism for the

parties to trade these contracts.

There is no default risk because the exchange acts as a counterparty,

guaranteeing delivery and payment by use of a clearing house.

The clearing house protects itself from default by requiring its

counterparties to settle gains and losses or mark to market their positions

on a daily basis.

Futures are highly standardized, have deep liquidity in their markets and

trade on an exchange.

An investor can offset his or her future position by engaging in an opposite

transaction before the stated maturity of the contract.

Example: Future Contracts

Let's assume that in September the spot or current price for hydroponic tomatoesis $3.25 per bushel and the futures price is $3.50. A tomato farmer is trying to

secure a selling price for his next crop, while McDonald's is trying to secure a

buying price in order to determine how much to charge for a Big Mac next year.

The farmer and the corporation can enter into a futures contract requiring the

delivery of 5 million bushels of tomatoes to McDonald's in December at a price of


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$3.50 per bushel. The contract locks in a price for both parties. It is this contract -

and not the grain per se - that can then be bought and sold in the futures market.

In this scenario, the farmer is the holder of the short position (he has agreed to

sell the underlying asset - tomatoes) and McDonald's is the holder of the long

position (it has agreed to buy the asset). The price of the contract is 5 million

bushels at $3.50 per bushel.

The profits and losses of a futures contract are calculated on a daily basis. In our

example, suppose the price on futures contracts for tomatoes increases to $4 per

bushel the day after the farmer and McDonald's enter into their futures contract of

$3.50 per bushel. The farmer, as the holder of the short position, has lost $0.50

per bushel because the selling price just increased from the future price at which

he is obliged to sell his tomatoes. McDonald's has profited by $0.50 per bushel.

On the day the price change occurs, the farmer's account is debited $2.5 million

($0.50 per bushel x 5 million bushels) and McDonald's is credited the same

amount. Because the market moves daily, futures positions are settled daily as

well. Gains and losses from each day's trading are deducted or credited to each

party's account. At the expiration of a futures contract, the spot and futures prices

normally converge.

Most transactions in the futures market are settled in cash, and the actual

physical commodity is bought or sold in thecash market.For example, let's

suppose that at the expiration date in December there is a blight that decimates

the tomato crop and the spot price rises to $5.50 a bushel. McDonald's has a

gain of $2 per bushel on its futures contract but it still has to buy tomatoes. The

company's $10 million gain ($2 per bushel x 5 million bushels) will be offset

against the higher cost of tomatoes on the spot market. Likewise, the farmer's

loss of $10 million is offset against the higher price for which he can now sell his

tomatoes.
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Fundamental Differences Between Futures andForwards

The fundamental difference between futures and forwards is that futures are

traded on exchanges and forwards trade OTC. The difference in trading venuesgives rise to notable differences in the two instruments:

Futures are standardized instruments transacted through brokerage firms

that hold a "seat" on the exchange that trades that particular contract. The

terms of a futures contract - including delivery places and dates, volume,

technical specifications, and trading and credit procedures - are

standardized for each type of contract. Like an ordinary stock trade, two

parties will work through their respective brokers, to transact a futurestrade. An investor can only trade in the futures contracts that are supported

by each exchange. In contrast, forwards are entirely customized and all the

terms of the contract are privately negotiated between parties. They can be

keyed to almost any conceivable underlying asset or measure. The

settlement date, notional amount of the contract and settlement form (cash

or physical) are entirely up to the parties to the contract.

Forwards entail bothmarket risk andcredit risk.Those who engage in

futures transactions assume exposure to default by the exchange'sclearing house. For OTC derivatives, the exposure is to default by the

counterparty who may fail to perform on a forward. The profit or loss on a

forward contract is only realized at the time of settlement, so the credit

exposure can keep increasing.

With futures, credit risk mitigation measures, such as regular mark-to-

market and margining, are automatically required. The exchanges employ

a system whereby counterparties exchange daily payments of profits or

losses on the days they occur. Through thesemargin payments, a futurescontract's market value is effectively reset to zero at the end of each

trading day. This all but eliminates credit risk.

The daily cash flows associated with margining can skew futures prices,

causing them to diverge from correspondingforward prices.
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Futures are settled at the settlement price fixed on the last trading date of

the contract (i.e. at the end). Forwards are settled at the forward price

agreed on at the trade date (i.e. at the start).

Futures are generally subject to a single regulatory regime in one

jurisdiction, while forwards - although usually transacted by regulated firms

- are transacted across jurisdictional boundaries and are primarily

governed by the contractual relations between the parties.

In case of physical delivery, the forward contract specifies to whom the

delivery should be made. The counterparty on a futures contract is chosen

randomly by the exchange.

In a forward there are no cash flows until delivery, whereas in futures there

are margin requirements and periodic margin calls.

forwards vs futures in commodity market

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