What Are Forward Contracts and Futures Contracts? Understand the Differences
Learn here what forward contracts and futures contracts are. Understand the differences between them and how they are applied in the commodities market.
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: Customization and Flexibility
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:
- Customization: Parties can adjust the terms and conditions of the contract according to their specific needs, such as the quantity of the traded asset and the settlement date.
- Liquidity: Generally, forward contracts are less liquid since they are customized and traded in the over-the-counter (OTC) market, not on a centralized stock exchange. In practice, contracted operations can be settled on the maturity date or an earlier date requested by the buyer, the seller, or by mutual agreement. Thus, the type of early settlement should be indicated at the time of the transaction.
- Credit Risk: Since these contracts are negotiated directly between the involved parties, there’s a risk that one of the parties may not fulfill its obligations upon maturity.
- Regulation: Forward contracts have less regulation since they are not traded on exchanges. This can offer more flexibility but can also result in less transparency for traders.
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.
Futures Contracts: Standardized Regulation
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:
- Standardization: They are highly standardized in terms of size, quantity, quality of the underlying asset, maturity dates, and other specifications.
- Liquidity: They are more liquid than forward contracts due to trading on stock exchanges. In practice, this means there are more participants willing to buy and sell these contracts.
- Margin Collateral: It’s an initial amount that a trader needs to have in their account to take a position in a futures market product, whether for buying or selling. It doesn’t represent a prepayment of the contracts traded but a guarantee that all commitments will be honored, considering possible adjustments due to price volatility.
- Organized Market: As they are traded on stock exchanges, transparency, regulatory oversight, and a secure trading environment are gained for participants. Daily, futures contracts are also adjusted based on market price changes.
- Variety of Assets: They can be based on a wide range of assets, including commodities and interest rates. As a result, there’s greater diversification of investment strategies and protection against risks.
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.
What Are the Main Differences Between Them?
To understand the main differences between them, let’s consider practical situations using the soybean commodity mentioned at the beginning of the text.
- Trading with Forward Contracts
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.
- Trading with Futures Contracts
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.
hEDGEpoint: Hedge Products for Businesses
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.
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