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Sunday, September 16, 2012

What are Forwards and Futures

Fundamentally, forward and futures contracts have the same function that both these types of contracts allow people to buy or sell a specific type of asset at a specific time in future, at a previously agreed price. The contracts, however differ in specific details.

Forwards & Futures Contract Features
A forwards contract or simply a forward is a non-standardized private contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today.
- As the name suggests, we look forward ahead of time to predict a price and decide the value of the Forward.
- Non standardized contract means that that the terms and conditions of the contract are not standard and would vary with each contract and the kind of asset being sold or bought.
- Future time means that the actual change of hands and payment of the asset would not happen now and would happen sometime in future.
- Price is agreed upon today between the seller and the buyer and is committed as a part of the contract

How a Forward / Futures contract works ?
Let us assume that you want to buy a house a year from now. At the same time, suppose that your friend, Ramesh currently owns a Rs. 50 Lacs house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of Rs.55 Lacs (a 10% appreciation assumed in one year). At this stage, both you and Ramesh have entered into a forward contract.

At the end of one year, suppose that the current market valuation of the house is Rs. 65 Lacs. Then, because Ramesh is obliged to sell this house to you for only Rs.55 Lacs,  you can easily make a profit of 10 Lacs. To see why this is so, one needs only to recognize that you can buy the house from Ramesh for Rs. 55 Lacs (as per the Forwards contract) and immediately sell to the market for Rs. 65 Lacs. In contrast, Ramesh has made a potential loss of Rs. 10 Lacs and an actual profit of Rs. 5 Lacs.

What is the purpose of Forwards / Futures contracts ?
Forward contracts offer users the ability to lock in a purchase or sale price without incurring any direct cost. This feature makes it attractive to many corporate treasurers, who can use forward contracts to lock in a profit margin, lock in an interest rate, assist in cash planning, or ensure supply of a scarce resources. 
Speculators also use forward contracts to make bets on price movements of the underlying asset. A very common example to hedge risks  is in cases like currency rate fluctuations. In currency forwards, one party opens a forward contract to buy or sell a currency to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counter party loses as one currency strengthens against the other.

Comparison of Forwards Vs Futures
a) Futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions.
b) Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.
c) For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract.
d) Settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.
e) Because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place. 
f) In contrast to forward contracts in which a bank or a brokerage is usually the counter party to the contract, there is a buyer and seller on each side of a futures trade.


Manoj Arora

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