Derivatives

[Annie]

Hi,

Can somebody tell me the difference between a future and a forward.

Annie

[Tia]

I'm assuming you know what both futures as well a forwards are, so here go the differences between them:

1. Forwards are over the counter derivative contracts, settled by delivery of goods at a specific date, while futures are settled by cash in a publicly traded futures exchange.
2. In futures the contract price is publicly disclosed, thus making it more transparent.
3. Futures are a more standardised form of forwards
4. Unlike futures, forward contracts do not require a specific margin.

Pritika.

[Annie]

Hi Pritika,

Thanks for it but it will be great if you can give me an example on each to understand them better.

Annie

[Snehal K]

Hi Pritika

I find derivatives difficult to understand. It will really help if you could explain a bit more along with examples.

[Tia]

Forward Contract
An example of a forward contract would be when a gold trade would enter into a contract with another party to sell gold at a future date in order to eliminate the risk of change in prices by that date. This contract would cover specific points such as:
• Weight and quality of the gold to be delivered
• The place of delivery
• The time of delivery
• The price which the purchasing party would pay

Futures contract
Now if the same gold trader would enter in to a futures contract with the purchasing party, to trade100 ounces of gold at $850 per ounce. If after the second day of trading, the settle price at the commodity exchange is $880 per ounce of gold. This would lead to a net loss of $3,000 to the gold trader while the purchasing party would have gained by the same amount. As a result, the initial margin accounts of the gold trader would reduce by $3,000 while the purchaser would increase by the same amount. This margin account would get adjusted at the end of every day of trading. On the next day of trading the futures exchange for the contract would open at the previous day’s settle price, i.e. $880. On the day the contract would expire, i.e. on final settlement of the contract, there would be no difference between the contract price and the prevailing spot price, thus ensuring that none of the parties make a profit or loss for the day.

Pritika.

[Annie]

Hi Pritika,

Thanks for that. But I am sorry I did not follow the Future contract. Forward contract was very well explained, so I got it. Can you please ellaborate on it.


Annie

[Tia]

Ok to simplify what I had posted earlier:

In a forwards contract, the price is settled at the end of the term mentioned in the contract. For instance, if a gold trader would have a futures contract to sell 100 ounces of gold after 3 months to another person, the price would only be settled and profit or loss be calculated at the end of the three months mentioned in the contract.

However, in a futures contract, a margin account would have to be maintained by a futures trader. Now if the same gold trader would enter into a futures contract to sell gold, this contract would be traded on a commodity exchange. The margin which the gold trader would have to maintain would be adjusted with the rise or fall in the price of gold on the exchange everyday. Therefore, if the contract was deliver 100 ounces of gold for $850 per ounce of gold, and the price of gold on the exchange would close at $880, this difference of $30 per ounce would be adjusted in the margin account. This exercise would be done on every day of trading the contract at the commodity exchange depending on the price of the gold unlike a forward contract when this would be done only one at the end of the term of the contract.

Let me know of any more issues.

Pritika.

[Annie]

Hi Pritika,

Thanks a lot. I could understand now what is futures and forwards.

Regards
Annie