Commodity Classroom: Forward and Futures Contracts

A Forward Contract is an example of a basic derivative contract so called because the contract derives its value from the price of the asset underlying the contract. Forward contracts are usually in the nature of Over the Counter contracts (OTC).

There are three parts to every transaction namely trading, clearing and settlement. In a spot transaction, all the three parts happen simultaneously. But in case of a forward or futures transaction, the three part operation is split.

A forward contract is a contract for buying and selling of a particular commodity on a future date at a price pre-agreed today. Thus the trading happens today (that is the parties agree to buy/sell from each other); but clearing and settlement will happen on a future date.

A Forward Contract is a contract for delivery of goods that is not a ready delivery contract. In other words, a Forward Contract is a contract where delivery or payment or both are completed beyond eleven days from the date of the contract. Such contracts are governed by FCR Act.

A Forward Contract is an example of a basic derivative contract so called because the contract derives its value from the price of the asset underlying the contract. Forward contracts are usually in the nature of OTC — Over the Counter — contracts which are customised to suit individual requirements.

On the other hand, when such contracts are standardised to lot size, quality parameters, delivery centres and so on, they are referred to as Futures Contracts and such contracts are usually traded on a futures exchange.

Hedging advantage

Both forward and futures markets offer or allow market participants to hedge their price risks that they face in the spot market. While forward market offers customised risk management, futures market offers standardised solutions.

While OTC trades need not be cleared on an exchange, futures contracts have to be cleared on an exchange.

There is no risk of counter-party default as the exchange acts as buyer to every seller and seller to every buyer. More distinguishing features of a futures contract include a transparent price discovery and mark-to-market as well as low entry/exit barriers.

Both forward and futures markets have grown rapidly in the last few years aided by development in technology which has made trading easier and faster.

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