Forward and Futures Contracts
In this article we introduce two examples of derivatives: forward and futures contracts. We also analyze the possible payoffs and profits of these two securities.
Forwards and futures are very similar as contracts but differ in pricing and trading mechanisms. For example, forwards are traded over the counter (i.e. contract specification can be customized) whereas futures are traded on exchange markets (where contracts are standardized). For the purpose of this section, we think of them as interchangeable
A forward contract (or a futures contract) is a commitment to purchase at a future date, known as the expiration date, the delivery date or the maturity date, a given amount of a commodity or an asset at a price agreed on today. The price fixed now for future exchange is called the forward price or the delivery price. The asset or commodity on which the forward contract is based is called the underlying asset. Apart from commissions and bid-ask spreads, a forward contract requires no initial payment or premium between the two parties. At the delivery date, cash is exchanged for the asset. Examples of forward contracts include
A bond forward is an obligation to buy or sell a bond at a predetermined price and time.
An equity forward is an obligation to buy or sell an equity at a predetermined price and time.
A gold forward is an obligation to deliver a specified quantity of gold on a fixed date and receive a fixed delivery price.
A foreign exchange forward is an obligation to buy or sell a currency on a future date for a predetermined fixed exchange rate. This type of forwards is used by firms as a protection against fluctuation in foreign currency exchange rates.
An interest rate forward is used to lock-in future interest rates. For example, a firm who is planning for a loan in six months can buy forward contract that lock-in the rate at the present. This rate will be the rate that will apply when the loan is exercised in six months. The risk here is that the firm will stuck with borrowing money at the stated rate so any decline of interest rates before the six months period will cause losses for the firm.
Explain in words the meaning of the following: A 3-month forward contract for 1,000 tons of soybean at a forward price of $165/ton.
In this contract, the buyer is committed to buy 1000 tons of soybean from the seller in three months for a price of $165 a ton
Read about the Forward pay off for more information