Forward and futures contracts are in a way like option contracts as they specify the terms of purchase or sale of some underlying security in future. However, there is one key difference. The holder of call (put) option enjoys the right to buy (sell) without the obligation to do so. A forward or futures contract however imposes a firm obligation to go through the transaction.
In a strict sense, a forward or futures contract is not an investment because no cash is paid to buy an asset. It is just a commitment to do a transaction future. Yet, they are considered as part of investments as they are powerful tools to modify portfolio characteristics and hedge other investments.
While forward contracts have been in existence for thousands of years, organized futures markets started in the 19th century. Futures markets play an important role in the world of finance. Many kinds of futures contracts have been developed and the use of futures has received a great deal of attention. Futures, like options are important derivative instruments and a major innovation in the field of finance.
Features of a futures Contract:
A futures contract is a standardized forward contract. So, let us first understand what a forward contract is. An agreement between two parties to exchange an asset for cash at a predetermined future date for a price that is specified today represents a forward contract. For example if you agree on January 1 to buy 100 bales of cotton on July 1 at a price of Rs 800 per bale from a cotton dealer, you have bought forward cotton or you are long forward cotton, whereas the cotton dealer has sold forward cotton or is short forward cotton. No money or cotton changes hand when the deal is signed. The forward contract only specifies the terms of a transaction that will occur in the future.
Note that the terms buy and sell have a somewhat different meaning here. It is helpful to think in terms of:
1. Short position which commits the seller to deliver an item at the contracted price on maturity; and
2. Long position which commits the buyer to purchase an item at the contracted price on maturity.
The forward buyer is obliged to purchase the underlying asset at the contract price or enter into an offsetting transaction. Likewise the forward seller is obliged to deliver the underlying asset at the contract price or enter into an offsetting transaction.
What are the payoffs to the forward buyer and the forward seller? When the spot price in future exceeds the contract price, the forward buyer’s gain is: spot price – contract price. If it is the other way round, the forward buyer’s loss is: contract price – spot price. The payoff to the seller of forward contract is the mirror image of the payoff to the buyer. The gain of the buyer is the loss of the seller, and vice versa.
Key differences between Forwards and Futures:
A standardized forward contract is a futures contract the key differences between forwards and futures are as follows:
1. A forward contract is a tailor made contract (the terms are negotiated between the buyer and seller), whereas a futures contact is a standardized contract (quantity, date and delivery conditions are standardized).
2. While there is no secondary market for forward contracts, the futures contracts are traded on organized exchanges,
3. Forward contracts usually end with deliveries, whereas futures contracts are settled with the differences.
4. Usually no collateral is required for a forward contract. In a futures contract, however, a margin is required.
5. Forward contracts are settled on the maturity date, whereas futures contacts are ‘marked to market’ on a daily basis. This means that profits and losses on futures contracts are settled daily.