A forwards contract is a highly customizable derivate contract that allows both the buyer and seller to buy and sell the underlying asset at an agreed-upon price. The nature of the forward’s contracts makes it ideal for hedging against any volatility in the market. But, the forward contracts have also been used in the past to speculate on particular types of assets. The forward contracts can magnify profits, but they can also magnify losses. The forward’s contracts are used for commodities, stocks, and bonds.
Example of a forwards contracts
Consider an example of an oil producer who is worried that there would be an oversupply of oil, and the price of oil would fall. The current market price of oil is fifty dollars per barrel. But, the oil producer thinks it would go down to thirty dollars per barrel. So, he makes a contract to sell the oil in the future for forty dollars.
There are two scenarios, the price of oil either rises or falls. If the price falls, the oil producers would still earn forty dollars per barrel, but they would have to take a loss if the price rise. This is how forwards contracts work.
What is Futures trading?
Futures are contracts that obligate the contract holder to buy the underlying asset at an agreed-upon price. The futures contracts are a hedging tool. They are mainly used to hedge against commodities. It provides a stable future price to the buyer of the commodity. This allows the trader on both sides to lock in the prices of a commodity.
Example of Futures trading
Take, for example, a farmer who has had a great corn crop, and he thinks that prices would fall as the market gets flooded with corn. So, he would go to the future trader who would pay him the current price of corn in the future when he sells the crop. The farmer is charged a small contract fee, but he knows for what price he will sell in the future, and then he can make his plans according to the money he will get in the future.
Main differences between forwards and futures contracts
The main differences between the forwards and futures contracts are given as follows:
i) Forwards contracts are not traded on a formal stock exchange but are traded over the counter or OTC. At the same time, the futures contracts are traded on the stock exchange. This is because forward contracts are not used much.
ii) There is also a higher risk of default on the forward’s contracts as there is no centralized clearing system like futures contracts.
iii) Forwards contracts also have a much higher risk of fraud than futures contracts because of their low demand and no regulations.
iv) The futures contracts are settled every day whereas the forward contracts are settled only once on the last date.
Similarities between forwards and futures contracts
As there are differences, there are also few similarities between the forwards and futures contracts.
i) Both oblige the investor to buy or sell the underlying security at an agreed-upon price in the future.
ii) Both expose the investors to have maximum liabilities.
iii) Both are used for hedging mainly, but also can be used sometimes for speculations.
Main types of Futures Contracts
There are two main types of Future Contracts. These both are shown in figure 1 below:
Figure 1: Types of Future Contracts
The two main types of futures contracts shown in figure 1 are commodities and financials. Both of these are explained in detail below:
Commodities futures contract
It is as the name implies a future contract for commodities. This future contract is primarily for commodities.
Financials futures contract
The financials futures contracts are used for financial products such as stocks or bonds. The futures contracts are not used as much for financials.
Main types of forwards Contracts
There are two main types of financial forwards contracts. Both of them are depicted in figure 2 below:
Figure 2: Types of Financial Forwards Contracts
The two main types of financial forward contracts shown in figure 2 are called Forward rate currency contracts and forward interest rates contracts. These financial forward contracts are mainly used by multi-national companies such as Apple to hedge against currency depreciation or rising or falling interest rates. They both are explained in detail below:
Forward rate currency contract
The forward rate currency contract is an agreement between the investor and the seller that they will exchange the two particular currencies at a specified exchange rate at a fixed date in the future. The net profits earned are based on the currency appreciation or depreciation minus the premium paid for the contract. The net losses are also based on currency appreciation or depreciation plus the premiums of the contract paid by the investor.
Forward Interest rate contracts
It also follows the same principle of forwarding currency rate contracts, but instead of hedging against the currency, the investor is hedging against the interest rates. The investor and the seller would agree upon a specific interest rate and how these interest rate changes would affect the underlying contract.
This is a complex futures contract and thus not a very common futures contract. The net profit or loss depends upon the interest rate agreed upon in the contract, and as a result, the net losses or profits are tough to figure out. There needs to be a detailed contract hammered out, and when both parties agree on the conditions, the contracts are signed.
The forward’s contracts are highly complex and unusual even by the standards of future contracts. That is why there is such a high rate among these contracts. Only the most sophisticated traders dare to use contracts forwards, and it is best to stay clear of them.