Introduction

In this chapter, we delve into the world of forward and futures contracts. These financial instruments play a vital role in risk management and speculation within various markets. We will explore the differences between forward and futures contracts and establish a clear understanding of the relationship between forward and spot prices.

Differences between Forward and Futures Contracts

Forward contracts and futures contracts are both agreements to buy or sell an asset at a future date for a predetermined price. However, they have distinct characteristics:

• Customization: Forward contracts are customizable agreements between two parties, whereas futures contracts are standardized and traded on organized exchanges.

• Counterparty Risk: Forward contracts carry a higher level of counterparty risk, as they depend on the creditworthiness of both parties. Futures contracts are guaranteed by the exchange, reducing counterparty risk.

• Secondary Market: Futures contracts have a secondary market where they can be bought or sold before maturity. Forward contracts are not as easily tradable.

• Settlement: Forward contracts typically involve physical delivery of the asset. Futures contracts can be settled either through physical delivery or cash settlement.

Example: Imagine a company wants to hedge against the price fluctuations of oil. They could enter into a forward contract with a supplier to buy oil at a specific price three months from now. On the other hand, they could also trade oil futures contracts on a commodities exchange, benefiting from the standardized terms and ease of trading.

Relationship between Forward and Spot Prices

The relationship between the forward (or futures) price and the spot price of an underlying asset is influenced by factors such as interest rates, storage costs, and convenience yields. The forward price reflects the market’s expectation of the future spot price.

Contango and Backwardation: Contango occurs when the forward price is higher than the spot price, implying an upward-sloping futures curve. Backwardation is the opposite, where the forward price is lower, indicating a downward-sloping curve.

Cost of Carry Model: This model considers the cost of holding the asset until the delivery date, including financing costs, storage costs, and potential income. The forward price is calculated using this model.

Example: If the spot price of a commodity is $100 and the cost of holding it for a year is $8, including interest and storage, the forward price using the cost of carry model might be $108.