Futures are exchange traded contract, or agreements, to buy or sell a specified quantity of financial instrument/commodity in a designated future month at a price agreed upon by the seller and buyer. Futures contracts have certain standardized specifications, such as:
i) quantity of the underlying
ii) quality of the underlying (not required in financial futures)
iii) date and month of delivery
iv) unit of price quotation (not the price itself) and minimum change in price (tick size). A tick is a change in the price of a contract be it up or down.
v) Location of settlement
Futures is a type of forward contract. The structure, pay-off profile, and basic utility for both futures and forward are the same. However, futures contracts differ from forward contracts in several ways:
1. Futures are exchange traded contracts, while forwards are OTC contracts, not traded on a stock exchange.
2. Futures contracts being traded on exchanges are standardized, that is, have terms standardized by the exchange. Only the price is negotiated. In contrast, all elements of forward contracts are negotiated and each contract is customized, that is, all the terms of a forward contract are individually agreed between two parties.
3. Futures markets are transparent while the forward markets are not transparent, as forwards are over the counter instruments. The latter are private bilateral agreements and as these agreements are not visible to other parties, the forward market is not transparent. In futures market, everyone can see the prices available as they are exchanged traded.
4. Futures contracts are usually more liquid than forward contracts, because they are standardized and traded on futures exchanges. In contrast, most forward contracts, due to their customized nature, are less liquid.
5. Futures contracts frequently involve a range of delivery dates whereas there is generally a single delivery date in a forward contract.
6. Futures contracts are marked to market daily whereas forward contracts are not.
7. Profits and losses on a future contract are realized on a daily basis (via the marking to market process). The profit or loss from a forward is realized when the contract matures.
8. Most futures contracts are closed prior to delivery whereas a forward contract is not usually settled until the end of its life. Hence, futures allow flexibility as to the date of closing out. Most forward contracts do lead to delivery of the physical onset or a cash settlement as they are not typically tradeable.
9. A futures contract can be reversed with any member of the exchange whereas a forward contract can be reversed only with the same counterparty.
10. The futures trading system has effective safeguards against defaults. Futures do not carry a credit risk, as there is a clearing house which guarantees both payment and delivery and delivery. Forward contracts, on the other hand, are exposed to default risk by a counterpart as there is no such clearing house involved.
11. Futures markets are regulated by a financial regulator, while forward contracts, in general trade in an unregulated market.
Thus forwards and futures are basically similar concepts. They differ only in terms of the institutional setting in which they trade, the degree of flexibility and cost efficiency. Futures are recognized as the best and most cost efficient way of risk hedging.
Need for Futures Markets:
Futures markets exist for several reasons:
1. Futures allow hedging adverse price changes. Hedgers transfer price risk to speculators who willingly undertake risk to take advantage of fluctuations in prices.
2. Futures help in price discovery. By observing the current futures price, producers and consumers can estimate what the future spot price will be or what future supply and demand of a good will be.
3. Futures prices contain and reflect information which helps in optimal allocation of resources.
4. Futures make transactions across time easier, speedier, and less costly. —