Forwards vs Futures

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Forward Contracts/Forwards

These are over the counter (OTC) contracts to buy/sell the underlying at a future date at a fixed price, both of which are determined at the time of contract initiation. OTC contracts, in simple words, do not trade at an established exchange. They are direct agreements between the parties to the contract. A clichéd yet Forward Contract goes thus:

A farmer produces wheat for which his consumer is the baker. The farmer would want to sell his produce (wheat) at the highest price possible to make some good money. The baker, on the other hand, would want to buy the same wheat from that farmer at the lowest price possible to save some good money assuming there is only one farmer for the baker or other farmers are in some way, a disadvantage for the baker. The price of wheat is the same for both the farmer and baker and keeps fluctuating – obviously!

All is fair if the farmer and baker sell and buy wheat as its price fluctuates as and when they transact (spot market), but the issue of not benefitting by price fluctuations are borne by both the farmer and baker – if at some date in the future the price of wheat fell, the farmer would not benefit and; the baker would not benefit if the price of wheat rose. They had to find a way out of this as they had little idea about how the price of wheat would evolve over time.

Cometh the concept of a Forward Contract to help both the farmer and baker. The contract gave a benefit where they could transact at a certain fixed price at a future date then be affected by the vagaries of price movements in wheat. Let’s assume that wheat was at $10/bushel in the spot market.

Since the farmer and baker want to protect themselves from disadvantageous price fluctuations, they enter into a forward contract where the baker agrees to buy say 30 bushels of wheat @ $10/bushel after one month from that farmer. Now regardless of how the price of wheat moves, both the farmer and baker are happy to have a fixed price to sell and buy in the future. They can get a nice sleep since the farmer isn’t going to get worried if the price of wheat falls, nor the baker would get worried if the price goes up – they have hedged their risk by entering into a forward contract.

Kindly note that the farmer vs. baker example is only indicative!

Using Forwards

I’ve already mentioned how forwards are used, but the purposes for which they are used are different. One is for hedging as the example suggested

Speculation

When one party just bets on the underlying price movement to benefit from the forward contract without having actual exposure to the underlying. The farmer produces wheat and thus has an exposure to the underlying. What if some trader who has nothing to do with wheat is betting on its price to fall and is thereby selling a Forward Contract just to make a profit?

You must be wondering what would happen to the counterparty if he has an underlying exposure, but the trader doesn’t! Right? If the trader and the counterparty don’t have any underlying exposure, it doesn’t really matter.

If the trader sells the forward contract (contract to sell the underlying) and benefits, in the end, he gets the money from the baker, for example (the fixed amount agreed in the forward contract), buys wheat at a lower price in the spot market at that time and gives it to the baker and keep the difference since the trader would benefit if wheat fell as he sold the forward. If the trader loses in the end, he’d have to buy wheat at a costlier price and give it to the baker.

If the trader buys the forward from a farmer, for example, and benefits in the end, then he pays the fixed amount and arranges to sell the wheat to a baker in the spot market at a higher price. If the trader loses in the end, he’d pay the fixed amount and then sell it to the baker at a lower price in the spot market.

The above assumes physical delivery. Generally, a trader enters into a contract to settle for cash where the profit/loss will be settled in cash between the parties to the contract.

Arbitrage

Forget the technicality for now, but if the participants to the forward contract feel that the forward is mispriced, then they take advantage of this by either buying or selling the contract and the underlying such that the balance is maintained and no more easy and riskless profits can be made. After all, if there is a free body with flesh in the ocean and its blood is sensed, why wouldn’t sharks go and attack it – the end result being that no more such free bodies exist after that!

Types of Forward Contracts

The type of forwarding Contract depends on the underlying. Thus the contract can either be on a company’s stock, bond, interest rate, a commodity like gold or metals, or any underlying you can think of!

Futures Contracts/ Futures

Futures Contracts are very similar to forwards by definition except that they are standardized contracts traded at an established exchange, unlike Forwards, which are OTC contracts. Please do not give this as a definition of a Futures Contract in an interview or exam – I would like you to frame it on your own because it would help! Though they are very similar to Forwards, the definition alone is not the only difference.

Key Differences Between Forwards and Futures

The structural factors in a Futures Contract are quite different from that of a Forward.

A margin account is kept in a place where Futures Contracts require the counterparties to put up some amount of money with the Exchange as ‘margin.’ Margins come in two types:

Initial Margin

This is an amount to be put up with the Exchange as you enter into the contract. This is similar to what we know as a ‘caution deposit.’ Depending on the daily profit or loss arising in a position, the gain/loss is either added to or deducted from the initial margin on the day of entering the contract and from the remaining amount held in the margin account from the end of the day till contract expiration.

Maintenance Margin

This is the minimum amount of money that has to remain in the margin account below, which that particular counterparty again has to put up to the level of the initial margin. In this case, a Margin Call is said to have been triggered.

Margins were introduced to keep the contract marked to market (MTM).

Here is a simple example to understand this:

Maintenance Margin Example 1
Maintenance Margin Example 1-1

The above example should be more than enough to clarify your doubts regarding Futures Contracts. Nevertheless, here are some points to note:

  • Numbers in parentheses/brackets indicate a loss/ a negative number.
  • Please look at the dates carefully.
  • Try performing the calculations of ‘Profits/Losses’ and ‘Margin Calls’ on your own
  • Notice the position that Mr. Bill takes. He has bought a Futures Contract in the first example and sold one in the second.

The example above is a very simplistic one but gives you an idea of how a margin account is maintained with the Exchange.

Why margin accounts? - Novation

You should’ve asked this question – what if one counterparty dies or defaults? If a counterparty says the buyer of the Futures dies and thus doesn’t respond at expiration, then the margin account balance gives a portion of the recovery to the seller. Then the Exchange pays up to buy the underlying from the seller in the spot market (since the spot price and futures price converge at expiration).

In other words, since futures contracts try to remove counterparty risk (as they are exchange-traded), there are margin requirements in place. Next, there are multiple futures prices that are based on different contracts. Forex, the June Contract Futures Price might be different from the September Contract Futures Price, which might be different from the December Contract Futures Price. But, there’s only one Spot Price always. Keep in mind that as the futures contract approaches expiration, the spot price and the futures price converge, and both are equal at contract expiration, not termination – remember the difference. This is also known as the ‘basis convergence’ where the basis is the difference between the spot and futures price.

The Exchange takes up counterparty risk called ‘Novation,’ where the Exchange is a counterparty. Take a look at the following picture:

Initial Contract – A and B have taken the respective positions on a Futures Contract through the Exchange

Forwards vs Futures

If B decides to terminate the contract before expiration, then the Exchange is the counterparty as it prevents A from being orphaned. It matches C to take the opposite position of B and thus keeps A’s position the same.

Forwards vs Futures 1

Notice that A’s position with the Exchange remains unchanged throughout. This is how trading futures benefit us since the Exchange takes opposite positions to help us out. How lucky are we!

Other Differences - Futures vs. Forward

The Futures market created liquidity by standardizing the contracts through the underlying in three ways:

Quality (Forwards vs. Futures)

The quality of the underlying, though, by definition, maybe the same, is not exactly the same. These are mentioned in terms of the contract. You may have an underlying as potatoes, for example. But the sand content may not be the same, or the number of pores may not be the same when it is delivered. Thus the specifics may not exactly be the same.

Quantity (Forwards vs. Futures)

You may want to trade only 50 potatoes for delivery else short term trading in the futures market. But the Exchange may allow you to only trade in lots of 10 where each lot consists of 10 potatoes. Thus the minimum number of potatoes you can trade is 100 potatoes and not 50, which is your requirement. This is another way standardization occurs.

Maturity (Forwards vs. Futures)

Maturity dates are available on the Exchange. For example, the last Thursday of each month is fixed as the maturity day. The immediate contract is called the near month contract (front-month contract); the contract maturing next month is called the next month contract (back month contract); contracts post that is called far month contracts—. The underlying is then bought or sold a few days after maturity, called as the settlement date.

You may want to buy the underlying on September 27th but can only do it on September 30th.

Types of Futures

Index Futures, Futures on stocks, Bond Futures, Interest Rate Futures, and several other types of futures exist.

Conclusion

There is a lot of information given – no doubt, almost everything you need to know about forwards vs. futures is present except for numerical problems. Due to its liquidity, Futures are more commonly traded than Forwards in general, although it depends on the underlying.