Forward contracts and futures contracts are types of derivatives used in the financial market, including for commodities. They function as financial instruments applied in the buying or selling of a specific asset on a future date at an agreed-upon price.
Through these contracts, traders seek to protect themselves from price fluctuations of the assets they are exposed to. For example, if a farmer plans to sell their soybeans in three months but believes that prices will have fallen by then, they can sell futures contracts for their crop to lock in the price.
If the future value falls below the agreed-upon value, they won’t experience losses, as the price was fixed earlier. This is a well-known hedging technique.
In this article, you will understand the concepts of these two contract models and how they are applied.
Forward contracts, also known as forward agreements, are agreements between two parties to buy or sell an asset on a future date at a pre-agreed price.
These contracts are negotiated directly between the involved parties rather than being traded on stock exchanges like futures contracts. Their main characteristics include:
One of the main advantages of forward contracts is the possibility of customization and flexibility. Additionally, the requirement for margin collateral is waived, and they do not have regulatory restrictions.
With forward contracts, it’s possible to hedge by protecting the asset, which will have the predetermined value for payment until the contract’s closing date. This practice neutralizes the volatility and risks of price changes in this asset over time.
On the other hand, futures contracts are standardized agreements traded on stock exchanges without direct contact between traders. These contract models have characteristics such as:
Futures contracts provide assurance in terms of volatility in the price of the underlying asset. One of their main advantages is the easy possibility of settlement by opening an opposing position in the same market.
Imagine you bought a futures contract to acquire an asset with 60 days remaining until maturity. Alternatively, you can execute another futures contract to sell the asset in 60 days. If the prices of both contracts are equal, there will be no impact on the overall position, making it possible to close it.
To understand the main differences between them, let’s consider practical situations using the soybean commodity mentioned at the beginning of the text.
João, a soybean producer, hasn’t harvested his crop yet and fears that prices will be very low when he sells it in 30 days. To ensure a selling price that guarantees profit margin, he finds a buyer who holds the opposite view.
So, they agree on a price of R$ 100 per sack and establish a quantity of 100 sacks for settlement in 30 days. After this period, the spot price is R$ 90.
The producer will deliver the soybeans at R$ 100 per sack, as agreed in the contract, making a profit of R$ 10 per sack compared to the market price at the time of maturity. However, the buyer will face a loss, paying R$ 100 for a commodity now worth R$ 90, resulting in a loss of R$ 10 per sack.
Imagine João bought soybean futures contracts for settlement in 6 months. He did this because he believes the prices will rise over time. To do this, he places a margin deposit.
Daily, the value of the contract purchased by João will be compared with the closing value of the soybean futures for the same maturity date as João’s contract. This procedure is called daily settlement.
If the price increases, the difference will be deposited into João’s account. Conversely, if the price falls, the difference must be deposited by João through a margin call.
João can settle his contract at any time by selling the contract to the market at the updated price and obtaining his final profit or loss.
As you can see, in futures contracts, trading is standardized and takes place on the exchange. In contrast, forward contracts are traded over the counter, are customized, and do not require margin collateral. Futures contracts undergo daily adjustments, following market changes. Therefore, the margin must always be met.
Understanding the differences between forward contracts and futures requires a deep knowledge of the commodities market. Turning to the use of derivatives is important to establish a well-defined strategy at the time of trading.
hEDGEpoint has professionals who work in this sector and master all these concepts. We offer hedge products that provide greater protection against price variation.