The futures market (part 9)

Posted by:

Forward and futures contract (part 9)

Both are agreement between two parties to exchange something in the future.

A forward contract is a commitment to purchase at a future date given an amount of something (commodity, FX, etc) at a price that is agreed to now.

The price (or the rate in case of interest or FX) will be fixed now for the duration of the contract. The buyer of the asset (commodity, interest rate, FX, etc) is said to be long the forward. The seller of the asset is said to be short the forward contract

What is so good about a Forward contract?  It is customized and is based on the agreement between the two parties.  There is no exchange market to trade forward futures contract, and can only be achieved through two parties agreeing on making the contract.

No money changes hands until maturity.  A default is treated through the legal system. It is basically no risk for most cases for both parties.

The future contract price has to be based on the understanding and the forecast by both parties believe that in the future the price will reach that level and we want to make sure that no one loses. Forward contracts allow parties to work their cash flows with reasonable certainty. Or I should say it eliminate uncertainty.

Futures contracts and Forward contracts are used for hedging.  The hedging has to take place because both buyers and sellers want to secure future price for buying or selling a commodity, or any asset.  It is also used to secure an interest rate when borrowing or lending and secure a foreign exchange rate when importing or exporting.