Forwards and Futures

In the past few months, we've talked about fundamental vocabulary, the idea of trading, making markets, retreating, and the different markets that exist. With the fundamentals of trading out of the way, let's dig into some of the slightly more complicated concepts: forwards and futures.

A forward contract (or simply forward) is a contract between two parties to buy or sell an asset at a specified time in the future for a priced agreed upon today.

An subset of forward contracts is futures contracts. A futures contract (or simply future) is exactly the same thing as a forward, except it is standardized, regulated, and traded on an exchange.

Here's an example of a forward contract. I'll give you $5 tomorrow if you give me a cup of coffee tomorrow morning -- Here, the two parties would be you and me; the contract is for me to give you $5 (the price agreed upon today) so I can receive a cup of coffee from you tomorrow (specified time in the future). In this context, you would be the seller of the forward contract since you received a predetermined price (money) and promised to deliver at a later date, and I would be the buyer. You and I can hash out the details of what type of coffee, where the delivery will take place, and more.

Whether you're aware or not, large banks will trade with each other in a similar manner, buying and selling financial instruments (commodities, currencies, risk) "over-the-counter" without any supervision of an exchange.

With a futures contract, all the details are already hashed out by the exchange. The exchange publishes these standards and calls them contract specifications

There are some clear advantages and disadvantages of trading "over-the-counter" versus trading on an exchange.

If a stranger came up to you and asked you to buy a corn forward from him (you promise to pay him $4 dollars in a month and he promises to give you a bushel of corn also in a month), you probably wouldn't take him up for the trade. Most likely, you would avoid this trade because there is too much risk in trusting a stranger with a promise to deliver. This is called counter-party risk and has to be considered when trading over-the-counter.

When you trade on an exchange, you are actually trading with the exchange. That is, if you went to the CBOT and purchased one corn future contract at the same time someone sold one corn future contract, you wouldn't be buying the contract from the seller but from the exchange. This virtually eliminates counter-party risk.

Another difference stems from the regulations on standardized contract specifications. At an exchange, you know exactly what you are getting, but you can't tailor the contract in any way to suit your needs. On the other hand, on OTC markets the flexibility can pose problems of its own; since not everyone knows what you are trying to buy/sell (it's not standardized), less parties are ready to trade (the party will spend time and resources to understand the new risks involved with a new contract). Whereas with a standardized contract, all parties involved know the risks beforehand.

In the next post, I plan on discussing how we determine the price of a future contract. Then we'll dig a little deeper with a couple of examples of contract specs and discuss some more important concepts that are crucial in understanding futures (and eventually options).