Futures and Forwards
These are contractual agreements employed by companies and investors for purposes such as risk hedging or speculation.
What are Futures and Forwards?
Futures and forwards are contractual agreements employed by companies and investors for purposes such as risk hedging or speculation.
Since the values of these financial instruments are derived from underlying assets, they are classified as derivatives. There are important differences between futures and forwards, even though they aim to set a fixed price for a given asset.
Both forwards and futures involve an agreement to purchase or sell an asset at a future date for a predetermined price. However, their main points of differentiation are their trading mechanisms and standardization.
Standardized agreements, known as futures contracts, are exchanged on designated exchanges. These standard features consist of terms such as contract size and expiration date.
The exchange acts as an intermediary, ensuring the completion of the deal. While this standardization enhances liquidity, it limits customization flexibility.
Forwards are tailored contracts that are directly negotiated between two parties. These customized agreements allow flexibility in contract size, expiration date, and other terms designed to meet the parties' unique needs.
However, a decentralized exchange might lead to less liquidity and more counterparty risk. Futures are standardized, exchange-traded contracts, while forwards are customized agreements negotiated directly between parties.
Both futures and forwards are useful tools for risk management and speculation. Various elements, including the requirement for customization, risk tolerance, and liquidity concerns, influence the decision between them.
Key Takeaways
- Companies and investors use futures and forwards, which are contractual agreements, for speculative or risk-hedging purposes.
- Exchanges facilitate futures contracts by serving as intermediaries to guarantee contract fulfillment. Because they are decentralized, forwards do not have a centralized exchange, which could result in lower liquidity and higher counterparty risk.
- Due to their standardization, futures have less flexibility but more liquidity. Conversely, forwards offer flexibility because they are customized, but their liquidity may be reduced.
- The usefulness of futures and forwards for risk management and speculation varies depending on the business's particular needs and goals.
Types of Underlying Assets
The underlying assets are crucial for investors to make an informed decision and manage risk in the derivatives market, and that derivative contracts are broadly divided into three categories:
1. Financial
- Diverse Instruments: Financial assets encompass various instruments, such as stocks, bonds, market indices, interest rates, currencies, etc. The homogeneity of these assets suggests that their characteristics are standardized and comparable.
- Centrality of Trading: Financial assets are exchanged on centralized, well-organized markets where buyers and sellers follow predetermined procedures. These well-run markets increase transparency and liquidity, making it easier for players to buy and sell financial instruments confidently and efficiently.
2. Commodities
- Tangible goods: Commodities include electricity, natural gas, sugar, coffee beans, gold, copper, silver, oil, and other tangible goods. Compared to financial assets, commodities exhibit less homogeneity, indicating that each one may have unique characteristics. These assets are traded on less centralized markets, indicating a global distribution of trading activity.
- Decentralized Market : A more decentralized trading environment for these physical goods is created because commodity markets usually involve a larger network of buyers and sellers than financial markets. The centralized and orderly structure of financial markets is well-known.
3. Other Types
- Custom and Private: It should be noted that these derivatives may not be traded on conventional exchanges but may take the form of special contracts arranged one-on-one between parties.
- Flexibility and Customization: Concerning mitigating risks associated with unforeseen events, this specific class of derivatives offers the parties a tailored, flexible, and adaptable solution to mitigate risks associated with unforeseen events.
Difference between Future and Forward Contract
The following are differences between Future and Forward Contract.
| Description | Forward Contract | Future Contract |
|---|---|---|
| Definition | It is an agreement between two parties to purchase or sell an asset at a predetermined price on a future date. | It is a standardized agreement to buy or sell an underlying instrument at a specific price on a futures exchange at a predetermined date in the future. |
| Structure | Customized. Typically, no initial payment is required. It is commonly used for hedging. | Standardized. A first-time margin payment is required. Usually used for speculative purposes. |
| Method of Transaction | Direct connection between buyer and seller | Traded in the stock exchange |
| Risk | High-risk | Low-Risk |
| Regulations | Not Regulated | Highly Regulated(the Commodity Futures Trading Commission or CFTC is the governing body) |
| Guarantees | Counterparties | Clearing House |
| Expiry Date | Custom dates - based on the transaction | Standardized |
| Contract Maturity Date | Matured once delivering the commodity | May not necessarily mature after the delivery date |
Forward Contract Example
Let us examine an alternative scenario involving XYZ Electronics, a manufacturing company, and its apprehension regarding volatility in the cost of copper, an essential raw material.
XYZ Electronics currently purchases copper from MetalCo, a regular supplier, for its electronic components for $3 per pound.
However, some market predictions point to a possible spike in copper prices due to rising demand from the electronics sector. Knowing there are unknowns, XYZ Electronics chooses to reduce this risk by negotiating a forward contract with MetalCo.
Following negotiations, MetalCo and XYZ Electronics settled on a forward contract that calls for the acquisition of 50,000 pounds of copper at the going rate of $3 per pound. The contract has nine months until it matures.
The following possible outcomes could occur.
Scenario 1 - Increase in Copper Prices
XYZ Electronics benefits from the forward contract by securing copper at the agreed-upon rate of $3 per pound if market conditions cause copper prices to spike to $5 per pound.
XYZ Electronics will save $100,000 in expenses. Conversely, Metal Co suffers a $100,000 loss since they must sell the copper for $2 less than the going rate in the marketplace.
Scenario 2 - Copper Prices Stay Stable or Drop
If copper prices remain stable or fall to $2 per pound, XYZ Electronics will have to pay $1 more per pound than the going rate, costing an extra $50,000.
In this case, Metal Co profits by selling the copper for $1 more per pound than it would have otherwise, or $50,000 more.
This example demonstrates how forward contracts can support companies in managing and hedging against future changes in the cost of necessary raw materials, guaranteeing operational stability and cost predictability.
Future Contract Example
Let us examine Tech Gadget Inc., a manufacturing company that bases its flagship product on a particular semiconductor component. The going rate for this component on the market is $10 per unit.
Foreseeing a potential surge in semiconductor prices amid geopolitical tensions disrupting global supply chains, Tech Gadget decides to proactively manage this risk by engaging in futures contracts with a six-month expiration date.
A single futures contract costs $ 10 and represents 1,000 semiconductor units, implying that each contract is worth $10,000.
Tech Gadget purchases 50 of these contracts for a total of $500,000. This ensures the future delivery of 50,000 semiconductor units during the specified delivery month.
Scenario 1 - Geopolitical Tensions Escalate
Escalating Geopolitical Tensions: Tech Gadget's futures contracts gain value if geopolitical tensions intensify and semiconductor prices rise to $15 per unit.
Tech Gadget made a $250,000 profit on the futures contracts when their value rose to $750,000, considering the initial investment of $500,000.
The company chooses to sell the contracts to finance the purchase of 50,000 semiconductor units at a price above market expectations.
Scenario 2 – Geopolitical Tensions Ease
Conversely, the futures contracts lose value if geopolitical tensions subside and the semiconductor market becomes stable, with prices falling to $8 per unit.
Due to the contracts' current $250,000 valuation, Tech Gadget experiences a $250,000 capital loss. The business reacts by selling the contracts and using the money received to purchase the necessary 50,000 semiconductor units at a lower price than the market.
With the help of futures contracts, businesses can manage supply chain risks, navigate market uncertainties, and make well-informed decisions based on anticipated price movements, as this example shows.
Conclusion
Futures and forwards provide avenues for risk management and speculation, making them vital financial tools for investors and companies.
Although these derivative contracts have the same objective of fixing the price of an asset in the future, they differ greatly in terms of standardization and trading methods.
Futures contracts offer more liquidity but less customization flexibility due to their standardization and exchange-based trading.
Conversely, forwards are customized contracts directly negotiated between parties; while they may offer more flexibility, they may also result in decreased liquidity and heightened counterparty risk.
The decision between futures and forwards is influenced by a number of variables, including the requirement for customization, risk tolerance, and liquidity concerns.
Different asset classes, including financial instruments, commodities, and custom/private contracts, underpin these derivatives. Each category's unique features and risks influence market participants' decision-making process.
The choice of underlying asset class or whether to trade futures or forwards ultimately depends on investors' and businesses' particular needs and objectives.
Making informed decisions in the dynamic world of derivatives requires a nuanced understanding of these financial instruments and their underlying assets, whether one is speculating on market movements or hedging against price volatility.
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