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Forward And Future Contracts

-By Abhinav Agrawal (Kanha Makhan Millennium School)

Forward contracts:

Forward or forward contracts are the contracts between two parties to buy or sell an asset on a certain date and at some pre-decided price. The certain date mentioned above is known as the expiry date of the contract and the pre-decided price is known as the forward price. The terms of the forward contracts are decided by the parties involved. Hence, it’s a private contract.
Forward contract includes a buyer and a seller. Buyer is the one who buys an asset and is also knows as a long investor and is said to have a long position whereas seller is the one who agrees to sell an asset and is also knows as a short investor and is said to have a short position.

A forward contract is generally carried out in over the counter markets because it does not have any higher authority to govern it.

Settlements of forward contracts:

PHYSICAL SETTLEMENT

In the physical settlement, the forward contract is settled by the actual delivery of the underlying asset by the short investor(seller) to the long investor(buyer) and the payment by the long investor(buyer) to the short investor(seller) on the agreed settlement date or expiry date.

Illustration:

Suppose A and B are two parties in which A is a farmer who produces potatoes and B is a owner of a chips company. A and B come into a forward contract on 1st October 2020 in which A agrees to give 100kg potatoes to B at a price of Rs.100/kg on 29th October 2020. Here A is a short investor and B is a long investor.

In the case of physical settlement, on 29th October 2020, A will have to deliver the 100kg potatoes to B and B will have to pay Rs.10000 to A. If in case A is not able to produce 100kg till the expiry date, he will have to buy the remaining amount of potatoes at spot price from someone else and deliver it to B.

The profit and loss for each party depends on the spot price of potatoes on 29th October 2020.  With this we can conclude three scenarios:

  • If the forward price is more than the spot price (Ft>St): Taking the above example, if on 29 October, the spot price of 1kg potatoes is Rs.90 then for 100kg potatoes, the total cost will be 90000 but party B still has to pay Rs. 10000 for 100kg potatoes because Rs.100/kg was the forward price/settlement price of potatoes. Thus party B will suffer loss of Rs.1000 whereas party A will get a profit of Rs.1000.
  • If the forward price is less than the spot price (Ft<St): Taking the above example, suppose the spot price of 1kg potatoes is Rs.110 then according to the spot price for 100kg potatoes, the total cost would be Rs.11000 but party A will get only Rs.10000 in the exchange of 100kg potatoes because the forward or settlement price was 100/kg. Thus, party A will incur a loss of Rs.1000 whereas party B will earn a profit of Rs.1000.
  • If the forward price is equal to the spot price (Ft=St): In this scenario, there will be no gain no loss to either of the party.

CASH SETTLEMENT

In the physical settlement, there is no actual delivery or receipt of securities. Either party pays/receives the cash equals to the net profit/loss out of their respective position in the contract.

In scenario 1, the Forward price was more than the spot price thus the long investor(i.e. Party B) was incurring the loss of Rs.1000. Hence the party with a short position(i.e. Party A) has to pay an amount equivalent to a net loss of the long investor. The opposite is the case in scenario 2 where Ft<St thus short investors will incur a loss of Rs.1000 and the party in the long position will simply pay Rs.1000 to the party in the short position.

DEFAULT RISK IN FORWARD CONTRACTS

The major risk in a forward contract is that they are prone to default risk. No matter whether the forward contract is for cash settlement or physical settlement, there always exists a counterparty risk i.e. there always exists a potential that one party may not honor the contract and can default. As in scenario 1, there are chances that the party in the long position can default, same in scenario 2 there are chances that the party in the short position can default. This happens due to the absence of a mediator between the two parties.

FUTURE CONTRACTS:

Similar to forward contracts, a future contract is the contract between two parties in which a buyer agrees to buy something from a seller at a future date at a price decided today. However, unlike forwards, futures is not a direct contract between a buyer and a seller i.e. it is not a private contract. It is done on a recognized stock exchanged. Stock exchange works as a mediator between a buyer and a seller. All the terms except the price is set by the stock exchange. In future contracts, buyers and sellers are protected by counterparty risk by an entity called clearing corporation.  A clearing corporation is an entity that makes sure that no party defaults, and it also guarantees the fulfillment of the obligation under the contract. To achieve this, the clearing corporation asks for certain amount from both the parties in the form of cash or other financial assets. This amount is known as the initial margin. In future contracts, parties have the flexibility to square off their position before the maturity date by squaring off the transaction in the market.