Along with some exception to forward contracts, there are future contracts. What makes future differ from forward contracts is that future’s are traded on stock exchanges while forward’s are traded on the OTC market. OTC or the over the counter market is a marketplace for typically forward contracts.
Another distinction relates to the settlement of the contracts. While futures, in general, settle daily whereas, forwards settle on expiration. The daily settlement is technically known as marked-to-market.
Futures are generally used to hedge the risk of price fluctuations by fixing the price in advance. Speculators also use futures to make a profit through analyzing and forecasting the future price movements.
Futures of Basmati Rice are being traded on a commodities exchange and each contract is for 100 kgs. Nita wants to buy 5,000 kgs of Basmati Rice during the last week of the month. While, Jay seeks to sell 5,000 kgs of Basmati Rice during the last week of the month. The futures contract is suitable for the both parties, as a trade could be executed between the two parties for 50 contracts on the exchange. The disadvantage of the futures is that the contracts are not customized as in forwards. For example, if both the parties in the above example wanted to trade 4000 kgs then the futures contract would not have served their purpose.
Advantages of Futures Contracts
It allows hedgers to shift risks to speculators.
It gives traders an efficient idea of what the futures price of a stock or value of an index is likely to be.
Based on the current future price, it helps in determining the future demand and supply of the shares.
Since it is based on margin trading, it allows small speculators to participate and trade in the futures market by paying a small margin instead of the entire value of physical holdings.
Risks of Futures Contracts
The main risk stems from the temptation to speculate excessively due to a high leverage factor, which could amplify losses in the same way as it multiplies profits. Further, as derivative products are slightly more complicated than stocks or tracking an index, lack of knowledge among market participants could lead to losses.
Who Uses Futures Contracts?
Speculators can use futures contracts to bet on the future price of some asset or security. Hedgers use futures to lock in a price today to reduce market uncertainty between now and the time that good is to be delivered or received. Arbitrageurs trade futures contracts in or across related markets, taking advantage of theoretical mispricing that may exist temporarily.
Futures vs. Forwards
These two types of derivatives contract function in much the same way, but the main difference is that futures are exchange-traded and have standardized contract specifications. These exchanges are highly regulated and provide transparent contract and pricing data. Forwards, in contrast, trade over the counter (OTC) with terms and contract specifications customized by the two parties involved.