What Are Forward and Futures Contracts?

Essentially, forward and futures contracts are agreements that allow traders, investors, and commodity producers to speculate on the future price of an asset. These contracts function as a two-party commitment that enables the trading of an instrument on a future date (expiration date), at a price agreed upon at the moment the contract is created.

The underlying financial instrument of a forward or futures contract can be any asset, such as equity, a commodity, a currency, an interest payment or even a bond.

However, unlike forward contracts, the futures contracts are standardized from a contract perspective (as legal agreements) and are traded on specific venues (futures contracts exchanges). Therefore, futures contracts are subject to a particular set of rules, which may include, for instance, the size of the contracts and the daily interest rates. In many cases, the execution of futures contracts is guaranteed by a clearing house, making it possible for parties to trade with reduced counterparty risks.

Although primitive forms of futures markets were created in Europe during the 17th century, the Dōjima Rice Exchange (Japan) is regarded as the first futures exchange to be established. In early 18th-century Japan, most payments were made in rice, so futures contracts started to be used as a way to hedge against the risks associated with unstable rice prices.

With the emergence of electronic trading systems, the popularity of futures contracts, along with a range of use-cases, became widespread across the entire financial industry.

Functions of futures contracts

Within the financial industry context, futures contracts typically serve some of the following functions:

Hedging and risk management: futures contracts can be utilized to mitigate against a specific risk. For example, a farmer may sell futures contracts for their products to ensure they get a certain price in the future, despite unfavorable events and market fluctuations. Or a Japanese investor that owns US Treasury bonds may buy JPYUSD futures contracts for the amount equal to the quarterly coupon payment (interest rates) as a way to lock the value of the coupon in JPY at a predefined rate and, thus, hedging his USD exposure.

Leverage: futures contracts allow investors to create leveraged positions. As contracts are settled at the expiration date, investors are able to leverage their position. For example, a 3:1 leverage allows traders to enter into a position three times larger than their trading account balance.

Short exposure: futures contracts allow investors to take a short exposure to an asset. When an investor decides to sell futures contracts without owning the underlying asset, it is commonly referred to as a “naked position”.

Asset variety: investors are able to take exposure to assets that are difficult to be traded on the spot. Commodities such as oil are typically costly to deliver and involve high storage expenses, but through the use of futures contracts, investors and traders can speculate on a wider variety of asset classes without having to physically trade them.

Price discovery: futures markets are a one-stop-shop for sellers and buyers (i.e. supply and demand meet) for several asset classes, such as commodities. For example, the price of oil can be determined in relation to real-time demand on futures markets rather than through local interaction at a gas station.

Settlement mechanisms

The expiration date of a futures contract is the last day of trading activities for that particular contract. After that, trading is halted and the contracts are settled. There are two main mechanisms for futures contracts settlement:

Physical settlement: the underlying asset is exchanged between the two parties that agreed on a contract at a predefined price. The party that was short (sold) has the obligation to deliver the asset to the party that was long (bought).

Cash settlement: the underlying asset is not exchanged directly. Instead, one party pays the other an amount that reflects the current asset value. One typical example of a cash-settled futures contract is an oil futures contract, where cash is exchanged rather than oil barrels as it would be fairly complicated to physically trade thousands of barrels.

Cash-settled futures contracts are more convenient and, therefore, more popular than physical-settled contracts, even for liquid financial securities or fixed-income instruments whose ownership can be transferred fairly quickly (at least comparing to physical assets like barrels of oil).

However, cash-settled futures contracts may lead to manipulation of the underlying asset price. This type of market manipulation is commonly referred to as “banging the close” – which is a term that describes abnormal trading activities that intentionally disrupt orders books when the futures contracts are getting close to their expiration date.