Understanding Futures and Forward Contracts: Key Differences

Futures and Forward Contracts

A forward contract is an agreement where one party promises to buy an asset from another party at a specified time in the future and at a predetermined price.

• No money changes hands until the delivery date or maturity of the contract.
• The contract creates a legal obligation to buy the asset at the delivery date.
• Underlying assets can include stocks, commodities, or currencies.

Understanding Delivery Price

The amount paid for the asset at the delivery date is called the delivery price. This price is set when the contract is initiated. As a financial derivative, the contract holds value. For example, John may sell his contract, while Peter may choose to purchase it.

Initially, the delivery price is set so that the contract has a value of zero for both parties. As maturity approaches, the value fluctuates:

• Long Position (Peter): The value equals the difference between the underlying asset price and the delivery price.
• Short Position (John): The value equals the difference between the delivery price and the underlying asset price.

Futures Contracts

A futures contract is similar to a forward contract but is typically traded through an exchange, which standardizes the contract terms.

Pricing and Settlement

Future prices for various maturities are quoted publicly. These represent the delivery prices for contracts initiated at the current time. Unlike forwards, the profit or loss from a futures position is calculated daily, and the change in value is settled between parties. This results in a gradual payment of funds from initiation until maturity.

Example: Assume at time t=0, the forward price of a ton of rice is 500 euros. At t=1, the price rises to 550 euros.

• Peter (Long): Agreed to buy at 500 euros; his profit at t=1 is 50 euros.
• John (Short): Loses 50 euros, which is paid to Peter.

While future prices vary daily, they must converge with the underlying asset price at maturity.

Primary Uses

Forwards and futures serve two main purposes: speculation and hedging.

• Speculation: If you anticipate a market rise, you can enter a long position to profit. Note that this strategy carries significant risk.
• Hedging: If you expect to receive payment in a foreign currency (e.g., yen) in six months but have expenses in dollars, you can use a futures contract to lock in a guaranteed exchange rate, mitigating currency risk.