Future and forward contracts (more commonly referred to as futures and forwards) are contracts that are used by businesses and investors to hedge against risks or speculate. Futures and forwards are examples of derivative assets that derive their values from underlying assets. Both contracts rely on locking in a specific price for a certain asset, but there are differences between them.
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Types of Underlying Assets
Underlying assets generally fall into one of three categories:
Financial
Financial assets include stocks, bonds, market indices, interest rates, currencies, etc. They are considered to be homogenous securities that are traded in well-organized, centralized markets.
Commodities
Examples of commodities are natural gas, gold, copper, silver, oil, electricity, coffee beans, sugar, etc. These types of assets are less homogenous than financial assets and are traded in less centralized markets around the world.
Other
Some derivatives exist as hedges against events such as natural catastrophes, rainfall, temperature, snow, etc. This category of derivatives may not be traded at all on exchanges, but rather as contracts between private parties.
Definitions
Forward Contracts
A forward contract is an obligation to buy or sell a certain asset:
At a specified price (forward price)
At a specified time (contract maturity or expiration date)
Typically not traded on exchanges
Sellers and buyers of forward contracts are involved in a forward transaction – and are both obligated to fulfill their end of the contract at maturity.
Futures Contracts
Futures are the same as forward contracts, except for two main differences:
Futures are settled daily (not just at maturity), meaning that futures can be bought or sold at any time.
Futures are typically traded on a standardized exchange.
The table below summarizes some key differences between futures and forwards:
Forward Contract Example
Suppose that Ben’s coffee shop currently purchases coffee beans at a price of $4/lb. from his supplier, CoffeeCo. At this price, Ben’s is able to maintain healthy margins on the sale of coffee beverages. However, Ben reads in the newspaper that cyclone season is coming up and this may threaten to destroy CoffeCo’s plantations. He is worried that this will lead to an increase in the price of coffee beans, and thus compress his margins. CoffeeCo does not believe that the cyclone season will destroy its operations. Due to planned investments in farming equipment, CoffeeCo actually expects to produce more coffee than it has in previous years.
Ben’s and CoffeeCo negotiate a forward contract that sets the price of coffee to $4/lb. The contract matures in 6 months and is for 10,000 lbs. of coffee. Regardless of whether cyclones destroy CoffeeCo’s plantations or not, Ben is now legally obligated to buy 10,000 lbs of coffee at $4/lb (total of $40,000), and CoffeeCo is obligated to sell Ben the coffee under the same terms. The following scenarios could ensue:
Scenario 1 – Cyclones destroy plantations
In this scenario, the price of coffee jumps to $6/lb due to a reduction in supply, making the transaction worth $60,000. Ben benefits by only paying $4/lb and realizing $20,000 in cost savings. CoffeeCo loses out as they are forced to sell the coffee for $2 under the current market price, thus incurring a $20,000 loss.
Scenario 2 – Cyclones do not destroy plantations
In this scenario, CoffeeCo’s new farm equipment enables them to flood the market with coffee beans. The increase in the supply of coffee reduces the price to $2/lb. Ben loses out by paying $4/lb and pays $20,000 over the market price. CoffeeCo benefits as they sell the coffee for $2 over the market value, thus realizing an additional $20,000 profit.
Futures Contract Example
Suppose that Ben’s coffee shop currently purchases coffee beans at a price of $4/lb. At this price, Ben’s is able to maintain healthy margins on the sale of coffee beverages. However, Ben reads in the newspaper that cyclone season is coming up and this may threaten to destroy coffee plantations. He is worried that this will lead to an increase in the price of coffee beans, and thus compress his margins.
Coffee futures that expire six months from now (in December 2018) can be bought for $40 per contract. Ben buys 1000 of these coffee bean futures contracts (where one contract = 10 lbs of coffee), for a total cost of $40,000 for 10,000 lbs ($4/lb). Coffee industry analysts predict that if there are no cyclones, advancements in technology will enable coffee producers to supply the industry with more coffee.
Scenario 1 – Cyclones destroy plantations
The following week, a massive cyclone devastates plantations and causes the price of December 2018 coffee futures to spike to $60 per contract. Since coffee futures are derivatives that derive their values from the values of coffee, we can infer that the price of coffee has also gone up.
In this scenario, Ben has made a $20,000 capital gain since his futures contracts are now worth $60,000. Ben decides to sell his futures and invest the proceeds in coffee beans (which now cost $6/lb from his local supplier), and purchases 10,000 lbs of coffee.
Scenario 2 – Cyclones do not destroy plantations
Coffee industry analyst predictions were correct, and the coffee industry is flooded with more beans than usual. Thus, the price of coffee futures drops to $20 per contract. In this scenario, Ben has incurred a $20,000 capital loss since his futures contracts are now worth only $20,000 (down from $40,000). Ben decides to sell his futures and invest the proceeds in coffee beans (which now cost $2/lb from his local supplier), and purchases 10,000 lbs of coffee.
Corporate actions.
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