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:: What are Forwards and Futures? ::

Forwards

A forward contract is an agreement between two parties for a pre-agreed price of a transaction that will take place some time at a future specified date. For example, one can have a future contract for £1 million pounds (Sterling) to be delivered at an exchange rate of 2.50 CHF (Swiss Francs) in 9 months time.

The forward contract obliges contractually both the seller of a contract (for example a bank) and the buyer (a company) to transfer, and receive, the money respectively as agreed. The buyer might see in a few months time that the contract is not in their favour, for example the exchange rate is now 2.60 CHF per STG and increasing day by day, and may wish to cancel the contract. The only way this can be done is to enter the reverse forward contract, with the same seller, but at the expense of a loss since a new forward rate will be agreed. Alternatively, the buyer might see that the contract is working in their favour and may wish to take the reverse forward contract in order to pocket the difference between the exchange rates at the later date.

Forward rate contracts are flexible and allow for customised hedges since all the terms are negotiated directly with the counterpart. However, each side of the contract bears the risk that the other side defaults on the future commitments.

Futures

Future contracts are very much like forward contracts only they are used to fix company interest rates, exchange rates or commodity prices. Futures are different to forwards in that the risk of default by either party is almost completely eliminated. Also, futures are traded with a clearinghouse which acts as the go between the buyer and the seller, unlike forwards where both parties deal directly with one another. The clearinghouse adopts the position of the buyer (seller) to every seller (buyer), so it effectively keeps a net zero position. Thus, the obligation of each contract is with the clearinghouse who is almost certainly expected to fulfil their part of the contract.

To ensure contracts are fulfilled, a margin is set and daily settlements are made. The margin is usually set to the maximum loss a trader can make in a normal trading day. The daily settlements are the amount that is lost (gained) on the day they occur.

Written by Alessio Farhadi

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