What are forward and futures contracts?

Introduction

Forward and futures contracts, in a unique capacity, operate as agreements that provide traders, investors, and commodity producers with a distinct opportunity to capitalize on future asset prices. These contracts serve as bilateral commitments that facilitate the trading of assets at a predetermined price, carrying through to a specified contract maturity date.

The underlying asset within forward or futures contracts can exhibit a remarkable diversity, encompassing stocks, commodities, currencies, interest rates, and even bonds, thus offering a level of uniqueness in the financial landscape.

Diverging from conventional forward contracts, futures contracts stand out as standardized legal instruments traded exclusively on specialized futures exchanges. These markets adhere to specific guidelines dictating contract size and daily interest rates, and, in many instances, they employ clearinghouses to ensure secure contract execution, rendering them unique in their approach to risk management during trading.

The history of futures markets has its own uniqueness, dating back centuries to their origins. Early versions emerged in Europe as early as the 17th century, but the title of the first official futures exchange belongs to Japan's rice exchange, Dōjima. During the early 18th century, Japan's reliance on rice as a primary medium of financial transactions gave rise to the use of futures contracts, offering a unique solution to combat price volatility.

In the modern era, the evolution of electronic trading systems has introduced unparalleled possibilities for leveraging futures contracts, leading to their exceptional prevalence throughout the financial industry.

Roles of Futures Contracts

The roles of futures contracts within the realm of finance generally encompass the following functions:

• Risk Management and Hedging: Futures contracts serve as a valuable tool for mitigating risks by fixing the future price of an asset. For instance, a farmer may use futures contracts to sell their agricultural produce, ensuring a predetermined price in the future, regardless of market fluctuations. Similarly, an investor holding U.S. bonds can opt for JPYUSD futures contracts to lock in the coupon price in Japanese yen at a prearranged rate.

• Leverage: Futures contracts offer investors the ability to trade with leverage. As these contracts settle in the future, investors can establish positions that exceed their initial capital. For instance, a 3:1 leverage allows investors to enter a position three times the size of their initial investment.

• Short-Term Access: Futures contracts provide an avenue for obtaining short-term access to assets. The sale of a futures contract without actual ownership of the underlying asset is referred to as a "naked position."

• Diverse Asset Exposure: Investors gain access to a wide array of assets that may be challenging to liquidate quickly. For example, commodities like oil often involve extra costs for transportation and storage. By utilizing futures contracts, investors and traders can speculate on various assets without the need to physically acquire them.

• Price Determination: In futures markets, sellers and buyers can effectively meet their demands for various asset types, including commodities. This ensures that supply and demand align efficiently, leading to real-time price discovery. For instance, the price of oil can be determined based on the prevailing demand in futures markets rather than relying solely on retail gasoline station trading.

Mechanism of Settlement

The mechanism for settling futures contracts involves the following key aspects:

Expiry Date: The expiry date of a futures contract marks the final day of trading for that specific contract. After this date, trading ceases, and settlement takes place. There are two primary methods for settling futures contracts:

• Physical Settlement: In this scenario, the underlying asset is exchanged between the two parties at a predetermined price. The party in the short (selling) position is obligated to deliver the asset to the party in the long (buying) position.

• Cash Settlement: With cash settlement, the actual asset is not exchanged directly. Instead, one party pays the other an amount reflecting the current value of the asset. An example of a cash-settled contract is an oil futures contract in which payment is made in cash, rather than physical oil delivery, which is convenient, especially considering the complexities of physically trading large volumes of oil.

Cash-settled futures contracts are generally more popular and convenient when compared to physically settled contracts. Even for liquid financial instruments or fixed-income instruments, for which ownership rights can be transferred relatively quickly (compared to physical assets like oil), cash-settled contracts are often the preferred choice.

However, cash-settled contracts can also be susceptible to price manipulation, including unusual trading activity aimed at disrupting the standard trading processes, particularly as the futures contract expiry date approaches.

Unique aspects of futures contracts exit strategies:

• Offsetting: This method allows traders to close their futures contract positions by executing opposing transactions with the same contract in the reverse direction at the exact price. This offers traders the flexibility to realize accumulated profits or losses and finalize their positions ahead of the contract's settlement date.

• Rolling Over: Rollover involves initiating a new position in a futures contract after offsetting or closing the previous one. It effectively extends the duration of the position. Traders can tailor their investment horizon by rolling over positions to meet specific market conditions or investment objectives.

• Settlement: In cases where traders choose not to offset or rollover their positions, the contract reaches settlement on its expiration date. This requires both parties to fulfill their contract obligations by exchanging assets or cash based on their positions. Settlement is particularly critical when physical delivery of assets is involved.

Each exit strategy provides unique advantages and flexibility, making it crucial for traders to consider their individual goals, market dynamics, and the requirement for asset delivery when choosing the most suitable approach.

Price Models for Futures Contracts: Contango and Normal Backwardation

Futures contracts introduce a dynamic interplay of market forces from their inception to their maturity. These fluctuations culminate in the establishment of two distinctive price models: "Contango" and "Normal Backwardation," each intrinsically linked to expectations regarding the future spot price of the underlying asset upon contract expiry.

• Contango: Contango materializes in a market scenario where the price of a futures contract surpasses the envisaged future spot price of the asset. This implies a collective trader belief that the asset's value will ascend by the contract's culmination. Catalysts behind this phenomenon may encompass ancillary expenses, such as warehousing or insurance costs. Contango predominantly favors sellers (those holding short positions).

• Normal Backwardation: Normal backwardation emerges when the futures contract's price is inferior to the expected future spot price of the asset. This signifies an anticipation among traders that the asset's value will diminish by the time the contract expires. Causative factors may encompass a surplus of the asset or a wane in demand. Normal backwardation generally aligns with the interests of buyers (those holding long positions).

The anticipated spot price signifies the foreseen future valuation of the asset at the moment of contract maturation. This valuation remains malleable, subject to market dynamics, including supply and demand fluctuations.

It is imperative to acknowledge that as the contract's expiration draws near, the futures contract's price typically converges toward the spot price until equilibrium is attained. When the futures contract and the spot price deviate at the contract's termination, arbitrage opportunities may arise.

Contango epitomizes trading futures contracts at prices exceeding the expected spot price, often for the sake of convenience and prospective cost savings. An illustrative instance involves a futures trader willingly incurring additional expenses for the delivery of physical commodities in the future, circumventing outlays associated with asset storage and insurance (as exemplified by the gold market). Additionally, corporate entities employ futures contracts as a safeguard against forthcoming expenses tied to commodities, procuring resources for their manufacturing processes. An exemplar is a bread manufacturer procuring wheat futures to hedge against future expenditures.

In contrast, normal backwardation unfolds when futures contracts are transacted at prices below the projected future spot price. Speculators might acquire futures contracts, banking on potential price escalation. A case in point is a trader securing a futures contract for oil at $30 while envisioning that the spot price in the forthcoming year will amount to $45.

Conclusion

Futures contracts represent a standardized form of forward contracts and are widely employed in the financial industry for diverse purposes. Despite their numerous advantages, comprehending the mechanisms and functions of the futures market is crucial before engaging in this form of investment.

The fixation of a future asset's price holds significance in various scenarios, but such operations can entail financial risks, particularly when employing leveraged transactions. To manage and mitigate the risks associated with futures, various strategies, including hedging, are utilized. Some investors and traders also employ technical and fundamental analysis to assess and forecast prices on futures markets.

Understanding these facets of futures contracts will assist investors and traders in better utilizing them in their strategies and making informed decisions in financial markets.