Understanding Forward vs. Futures Contracts
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The Forward Contract
a-Definition
It is very important to understand a forward contract to determine the forward price, and
enter the difference with a futures contract. These financial contracts indeed among
the most traded on the planet.
A forward contract is simply an agreement between two parties to buy or
sell an asset at a later date, for a price set in advance.
Like call or put options, it is important to design a contract.
forward as a hedging tool above all, and not for pure speculation.
Unlike a call or a put, however, the investor has the obligation to
carry out the exchange on the agreed date.
Let's imagine that you are the treasurer of a French company that receives
dollars and euros in the context of its activity. You have two options:
Either change dollars to euros on a daily basis (spot market)
Either exchange dollars for euros at a future date
Entering into a forward contract can be interesting if you know that you will
receive dollars (10,000 USD) in a month for example, and that you wish
convert them because you are closing your year-end accounts. You can therefore
take a position in a forward contract that will give you the right to sell your
dollars and buy euros in a month, for a given quantity and a set price at
the advance. Thanks to your bank, you find another company that would like to,
she, take an opposite position and an equivalent amount (that is to say, sell some)
euros to buy dollars).
Example:
The one-month forward exchange rate is set at 1.25. This means that you will have the
right to exchange your 10,000 USD for 10,000 / 1.25 = 8,000 EUR.
What will happen in a month? On the initial date, you entered at a forward price,
So fixed, at 1.25 USD for 1 EUR. In the meantime, the exchange rate has evolved. A
A month later, the exchange rate is finally 1.30 USD for 1 EUR.
At the level of your flow, you are satisfied, as you were able to exchange your 10.
000 USD for 8,000 EUR thanks to your forward. And what if you had waited until the last.
minutes to change them, without a forward contract, you would only have recovered 10,000
USD / 1.30 = 7,692 EUR, which represents a potential loss of 8,000 - 7,692 = 308 EUR for
your company. However, if the exchange rate was ultimately 1.20 USD
for 1 EUR, you could have exchanged your dollars for 10,000 USD / 1.20 = 8,333
EUR. You could have made an additional profit of 8,333 - 8,000 = 333 EUR.
As treasurer, your main priority was primarily to have perfect control
the flows of your business. You were not there to speculate on the evolution of
currencies, and that is why a forward contract allowed you to control the flows.
What is a Futures contract? What is the difference between a
What is a Forward contract and a Futures contract?
1-Definition of a Futures Contract
It is important to distinguish between a Forward contract and a Futures contract.
The two contracts are agreements between two parties to sell/buy an asset.
but Forward contracts are made directly between the two parties, while
Futures contracts are established through an organized market, they are standardized.
delivery date (or delivery period), the quantity, sometimes the quality and the place
are thus specified by the exchange on which these contracts are traded. The
buyers and sellers do not know each other.
Furthermore, one of the most important features of Futures contracts is the
setting up margin calls. Indeed, as the value of a contract evolves
over time (depending on the evolution of the spot price), each party may lose
money. Margin calls aim to ensure that final payments will be
Well, the potential gains/losses are settled on a daily basis with the
new evaluation of contract value, it is also what is called the mark-
to-market.
2-Comparison between FORWARD contract and FUTURES contract
*Forward contracts
Forward contracts are over-the-counter contracts between two entities.
There are no financial intermediaries between the two, the contract is negotiated directly.
Both parties are obliged to fulfill the contract and to respect their obligations.
engagements.
The forward contract is essentially used by companies looking to
to protect oneself from market risk. This is the case for companies that have access to
the international.
Let's take the example of a company that imports raw materials for its
activity in France. The raw materials are priced in Dollars (and the company
it will therefore have to pay in Dollars) and their cost is therefore directly linked to the exchange rate
from the EUR/USD. Let's assume that the company anticipates an order for materials
first in 3 month. She a so two possible choices :
To change Euros into Dollars in 3 months on the spot market.
In this case, the company is facing a currency risk. If the Euro depreciates against
The Dollar on the Forex will make raw materials more expensive to import.
the opposite, if the Euro appreciates against the Dollar, the cost of raw materials will be
less high.
Either change your Euros into Dollars in 3 months at a set price in advance, for a
predefined amount using a Forward contract. The company is then hedged.
against the exchange rate risk on EUR/USD. The Forward contract facilitates the management of the
the company's treasury. They know in advance how much they will spend for
acquire the subjects firsts.
Forward contracts offer the advantage of being very flexible.
The two parties can agree on the amount they wish, on the date for them.
choice and there is negotiation on the price. Forwards thus allow to respond
accurately to the needs of the business. Furthermore, their cost is reduced due to
that no commission is taken by a financial intermediary (as is)
the case on the markets organized).
Futures contracts
The contractsFuturesare contracts made on organized markets. The
contracts are standardized (fixed due date and amount) and buyers and
sellers gardened anonymity.
Unlike Forward contracts, somemargin calls are carried out
daily by a clearing house for the entire duration of
contract. These margin calls depend on the evolution of the spot (price at
cash) in relation to the price set on the Futures contract. Each day, the
gains/losses are so cashed/uncashed.
It should be noted that on Futures, the contract can be terminated at any time by one party.
des deux parties. Ce sont des produits financiers très liquides pour la plupart et il est
so possible to buy or sell à at any time during the contract.
The majority of transactions in Futures are for speculative purposes.
futures very rarely reach maturity and the delivery of the contract therefore does not occur
almost never
Difference between Forwards and Futures
Forward Future
Main Use Cover Speculation
Type of contract Gré à gré Organized market
Margin call No Yes
Early rupture of No Yes
contract
Anonymity No Yes
Standardized Contract No Yes
Transaction fees No Yes
Risk of deficit Yes No