Forwards and futures have much in common. Both are present contracts that commit one party to deliver certain goods, merchandise currency, etc. and the other to pay with the delivery and the payment to take place at a later date.
Today you agree to sell your car to somebody when you return from vacation. Assuming this has all the elements of a contract, you have entered into a forward contract. You car is not, of course, the sort of thing we have in mind when we talk about derivatives so that transaction will not be explored further here.
Suppose your company anticipates needing 400 million English pounds six months from now. You, the CFO, are quite comfortable with the current exchange rate between dollars and pounds and you are even comfortable with the exchange rate which various experts in the currency markets think will prevail six months hence. What you are not comfortable with is the experts and their predictions. You know that there is some volatility in the foreign exchange markets and you feel that the potential change in these rates over the next six months adds an element of risk to your business that you would like to avoid. Accordingly you enter into a contract today with a financial institution (possibly a large local bank or possibly an English bank) to buy 400 million pounds from the instition six months hence at a price specified now, a price specified in US dollars. You have entered into a forward contract involving the price of English pounds in terms of dollars (the "underlying") for 400 million of those pounds (the "notional amount"). This contract is a derivative contract.
Your company, a large food processing company, will also be buying a large quantity of No. 2 Hard Red Winter wheat a few months after the harvest season and you and your purchasing agent are nervous about what the price of that wheat may be. If, for example, the intervening harvest is bad, the price of wheat may soar with detrimental effects on your company's income. You enter into futures contracts involving several million bushels of No. 2 Hard Red Winter wheat to be completed shortly after the time you will need the wheat. So far the forward contract for English pounds and the futures contract for wheat sound identical and certainly they have much in common. Both contracts are derivatives that contemplate a future transfer of something (a foreign currency, a commodity, etc.) in exchange for a payment at that later date.
There are, however, some important differences.
| Organized exchanges |
Futures contracts are always traded on an organized exchange such as the Chicago Board of Trade or the Chicago Mercantile Exchange. |
| Standardized packages |
Whereas a forward contract is for whatever quantity, date, etc. the parties negotiate, a futures contract is a standardized package. The wheat futures are for 5,000 bushels (not 5,100 bushels) and the expiration months are July, September,December, March and May. The quality, delivery terms, minimum price fluctuations, daily price limits, trading hours, etc. are all established. |
| The clearing- house |
While the futures transaction does take place between a buyer of the commodity, metal, financial instrument (the "long") and the seller (the "short"), a clearinghouse immediately steps in between the two parties. The buyer and seller both look to the clearinghouse to live up to the terms of the contract. If the seller wants delivery of the commondity, it is the exchange that will find a counterparty (not necessarily and only rarely the original counterparty) to live up to the other side of the deal. |
| Regulation |
While everything about modern life is regulated - the state is everywhere - futures markets are more tightly regulated than forward markets. For example, the types of futures contracts to be offered on the various exchanges must first be approved by a regulatory authority such as, in the US, the Commodity Futures Trading Commission (CFTC). |
Among the dozen or so other significant differences between forwards and futures, one that deserves particular comment is how the contracts are completed, settled or terminated. While forward contracts are usually settled by performance, it is rare for the parties to a futures contract to ever complete the contract by making delivery of the wheat, metal, etc. A forward contract might involve a deal between a US manufacturer and the Bank of Montreal to buy a certain number of Canadian dollars at a later date; in most cases, when that date arrives, this being a forward contract, the US company will pay so many US dollars to the Bank of Montreal and the Bank of Montreal will "deliver" or credit the agreed upon number of Canadian dollars to an account for the US manufacturer.
By contrast, in a futures contract, it is rare for the "long" to expect to accept delivery and it is unusual for the "short" to plan to deliver. Both parties will terminate their position by making a contrary trade. The buyer in the futures contract (the "long") will, at some later date, when the futures contract has fulfilled its purpose, make an offsetting sale and the clearinghouse will offset his purchase and his sale and his position has been closed. (His sale will, by the way, typically bring another party into the market, the counterparty to his sale and that counterparty will now be long.) At a later date, the original seller (the "short") may likewise decide that the arrangement has fulfilled her purpose and she may then make a purchase of the same futures contract; again, the exchange offsets her short and long positions and she too is out of the market. Depending on the type of futures contract, only one to five percent are settled by delivery of the notional amount of the underlying.
To illustrate, suppose a flour company will need 500,000 bushels of wheat several months hence and is nervous about the prospective price of wheat at that time. What will that price be? The miller can look at the current futures price for, say, September wheat and can get some idea of what informed traders think that price will be. Unfortunately, September being still many months off, a bad harvest, changes in government policy, an international crisis, and many other factors may affect that price. If the miller is satisfied with the current futures price and does not want to take his chances on the changes that may occur in that price in future months, the miller can buy 100 contracts of September wheat. (Recall that a wheat contract is for 5,000 bushels so that 100 contracts will be for 500,000 bushels.)
Suppose wheat prices rise between now and September and October when the miller needs the wheat. (And suppose that increase in price takes the September "spot" or "cash" price above the futures price at which the miller contracted.) Chances are the miller will buy his wheat through the normal channels that he buys wheat and will pay the higher prevailing price for wheat at that time. (That's BAD.) But sometime in September the miller will have sold his 100 contracts of September wheat. Since these contracts give the right to buy wheat at the lower price at which wheat was selling several months in the past, the contracts have a value and the miller will make a profit. (That's GOOD.) The miller probably paid nothing when he entered into the futures contract in the past. (There will, of course, be some commissions to be paid and margin will typically have to be posted.) When the miller closes his contract by selling it in September, he will receive money and that money will largely offset the increase in price the miller will have to pay for the wheat, the increase, that is, over an above the futures price prevailing at the time of the initial contract. The miller has thereby insulated himself from the higher price and the consequent loss.
He has, of course, also insulated himself from the gain that would have occurred if the price of September wheat had gone down below what the September future implied at the time of the original contract. Had he not entered into the futures contract, he would now be able to buy the wheat at the lower price. Yes, he will still buy the wheat at the lower price but, to settle his September futures contract, a contract to buy wheat at the higher September price contemplated several months ago, he will have to pay money. The reduced price he pays for the wheat in September will be offset by the amount he must pay to get out of his futures contract.
Note that whether the spot price in September exceeds or falls below the September futures price that prevailed months ago, the miller's net position will be that he neither gains nor loses from that price movement. Notice also that in neither case will he typically accept delivery on the futures contract. Yes, the exchanges do have mechanisms for delivery to take place by warehouse receipts being delivered but actual delivery is rare. The miller buys wheat through normal channels and simply uses the futures contract to "hedge" against an unfavorable movemenet in prices recognizing at the same time that he is forsaking the opportunity to profit from a favorable movement of prices.
Let's plug in some numbers and deal with a concrete example involving a speculation. Brian, on the basis of some thorough research (he has spoken to his astrologer, consulted the tea leaves and purchased a perfect crystal ball) knows that the price of a particular commodity will increase considerably by December.
| DATE | SPOT PRICE | DEC.FUTURE PRICE |
| March 31 | $5 | $5.50 |
| December | ? | ? |
Here is his March 31 transaction. He buys 100 contracts of December futures at the futures price of $5.50 a bushel. Let's suppose the contract for this commodity is for 5,000 bushels so Brian is contracting to buy 500,000 bushels in December at $5.50 a bushel. He won't have to pay the $5.50 now; he is contracting to pay $5.50 a bushel in December. Yes, some money will trade hands now. He will have to pay commissions and other transaction costs. Also his broker and the exchange will want assurance that when December comes Brian can perform his part of the bargain; namely the brokerage firm will require Brian to post "margin" so they can be sure Brian can pay the $2,750,000 his contract implies. (The margin will, however, only be a very small part of the $2,750,000. The exchange will only be concerned with getting a part of the extent to which the price goes up or down. The position can always be liquidated so that the exchange doesn't need to worry about the full $2,750,000, but only about the extent to which that number will fluctuate.) The futures market has a complicated system of initial margin, maintenance margin and variation margin that you will have to check out before you enter into a futures transaction. For simplicity, let's suppose that Brian has lots of securities and funds on deposit with his broker so that no further margin need be posted.
Comes December and as the contract approaches expiration - OUCH! - the futures price and the spot price converge to $5.40. The %#@ tea leaves were mistaken. Brian decides to tear up his futures contract and tells his broker not to bother getting the 500,000 bushels. His broker, however, reluctantly explains to him that a futures contract is not quite the same as, say, a call option. If you buy a call on some stock at $50 and the price of the stock drops to $45 as the option is about to expire, you just let your option expire worthless. The option gives the buyer the right but not the obligation to buy the stock at $50. By contrast, Brian must - unless he does something to settle that contract - pay $2,750,000 for 500,000 bushels of the commodity. If he goes through with the contract, he may then turn around and sell the commodity on the spot market for the prevailing price of $5.40 or a total of $2,700,000. Notice that Brian pays $2,750,000 for the 500,000 bushels and then sells it for $2,700,000. He has lost $50,000 on the transaction.
Will Brian actually accept delivery? Probably not. His broker informs him that he can get a warehouse receipt delivered to him within the next day or two and Brian takes a good look at his garage and basement and decides he doesn't want to go through with the deal. "What can I do?" he asks his broker. She explains to him that he can close his position by making an offsetting trade. He has bought December futures; he can now sell December futures for the same number of contracts of the same commodity and he is out of the market. Unfortunately, he is selling an obligation to buy the commodity at $5.50 and the commodity is only worth $5.40. To get out of the position he will have to pay the difference of $0.10 per bushel or $50,000. Anyway you look at it, Brian has lost $50,000.
Who was on the other side of Brian's deal? At the inception of a futures contract there is a counterparty. True, after the deal is made, the clearinghouse steps in between the two parties and is, in a sense, the counterparty for both the long (Brian) and the short. But even then there are as many contracts long as there are short and the clearinghouse is just a traffic cop between the longs and the shorts. There is still, in a sense, a counterparty to Brian's contract and the only problem is that Brian doesn't know the identity of that counterparty. (For that matter, he won't know the counterparty when he made the original deal. It would have been handled for him by his broker and the exchange.)
Let's say the counterparty when Brian made his original deal was a merchant that had a large inventory of the commodity that it did not expect to sell until December. This counterparty, unacquainted with scientific decision theory, had not done the same market research as Brian and did not have any strong opinion about what the price would be in December. Furthermore, it didn't want to have to worry about what that price would be. It was satisfied with the $5.50 that some market participants forecasted would prevail in December. It wanted to "lock in" a price of $5.50 and it wanted to isolate itself from the risks involved in the fluctuations in that commodity's price. It didn't want its inventory to go down in value if the December price were lower than the March price and it was willing to forego any profit that would eventuate if the December price exceeded $5.50. Accordingly it sold 100 futures contracts of 5,000 bushels each for December delivery at $5.50.
When December arrives, the spot and futures prices for the commodity converge, as noted above, at $5.40. Does the company actually deliver the commodity and collect the $5.40 per bushel? Chances are it does not. In all likelihood, it sells its 500,000 bushels in the normal channels it usually employs and gets only $2,700,000 for it. That's less, $50,000 less, than the $2,750,000 that market participants back in March were predicting would be realized in December. But offsetting this $50,000 loss is a $50,000 gain on the futures contracts. The company sells these contracts at $0.50 a bushel since they provide for delivery at $5.50 when the prevailing price is only $5.40. The company ends up with the same net effect as if it had been able to sell the commodity in December at the predicted $5.50.
What would have happened if the December spot price had been $6 as Brian had anticipated? Presumably the company is able to sell its inventory at $3,000,000 instead of the $2,750,000 that market pundits would have predicted back in March. That $250,000 "gain" is good. But there is an offsetting loss on the futures contract of $250,000. Having sold a futures contract back in March and thereby committing itself to sell the commodity at $5.50 a bushel, it it wants to "undo" the contract by buying a contract it will have to pay $0.50 a bushel. Bear in mind that it is getting rid of a obligation to sell a commodity at $5.50 when the going price is $6 a bushel. The offsetting loss again means that the deal made back in March gives the company the opportunity to lock in the price of $5.50 that informed participants in the market thought would prevail in December.
In a sense, if we ignore transaction costs, the futures market may be considered a "zero sum game." The $50,000 loss of Brian matches up with a $50,000 gain to the merchant. And the potential gain of $250,000 to Brian would correspond to a $250,000 loss to the merchant. What one party loses, the other gains.
Notice a very significant difference between the speculator and the merchant. The speculator is entering a very risky market. Brian's loss was $50,000 and the gain, had the spot price been $6 in November, would have been $250,000. Those are substantial losses and gains when you bear in mind that the initial contract, ignoring transaction costs and margin, involved no outlay by Brian. If we measure risk by how much the outcomes may differ from the expectation, futures markets (and derivatives in general) tend to be very risky for the speculator.
By contrast, the merchant, instead of increasing his exposure to risk by entering into a futures contract, is reducing it. He is "hedging" his bets or reducing his risk. He will not be hurt by the bad outcome but, on the other hand, he will not benefit from the good outcome.
Let's continue this discussion by looking a little more closely at the players and the purposes of derivatives.
PLAYERS AND PURPOSES
Other possible destinations: