WHAT IS A FUTURES/FORWARD CONTRACT?
A futures/forward contract is simply this:
The obligation to exchange an underlying (such as 100oz of gold) at an agreed price and at an agreed date in the future.
HOW DOES A FUTURES DIFFER FROM A FORWARD contract?
They are very similar. In fact a futures contract is just a standardized forward contract that trades on an exchange. Here are the key differences:
FORWARD CONTRACT |
FUTURES CONTRACT |
A contract to exchange an underlying at an agreed price at an agreed date in the future |
A contract to exchange an underlying at an agreed price at an agreed date in the future (the exchange sets certain standardized dates to choose from) |
Is an over-the-counter (OTC) agreement between two counterparties
*therefore is generally un-regulated |
It is an exchange traded contract
*therefore it is generally regulated |
The amount of underlying to be exchanged is flexible and agreed upon by the two counterparties |
The minimum amount of underlying is standardized and set by the exchange (ie: Gold contract is 100oz) and differs for each underlying. |
The date of agreement is flexible and is agreed upon by the two counterparties |
Each underlying has standardized expiration dates and months. |
There is a credit risk of counterparty default |
The exchange's clearinghouse acts as counterparty on all contracts alleviating credit risk and sets margin requirements |
No margin requirements (unless specified) |
Margin requirements set by the exchange |
| Private transaction |
Transparent market |
Evidence shows that Forwards contracts have a history going back several millenniums. Ages however, the history of futures trading is much shorter.
1848 Chicago - THE BIRTHDATE OF FUTURES CONTRACTS
In 1848 the Chicago Board of Trade (CBOT) was established creating the world's first futures and options exchange. The CBOT evolved from the need for a central place for sellers, buyers, and traders to meet - particularly in the grain markets. Once the meeting place was established the next step was to create standardized contracts. In a forward contract the buyer and seller agree on the size… for the exchange this would create too many odd sized contracts making it difficult to trade or offset to another person. So, for corn 5000 bushels was made the standard contract, wheat and soy beans the same. This way if a farmer was expecting a harvest of 23,000 bushels and was happy with today's price he could lock it in via a futures contract by selling 5 futures contracts (5 x 5000 = 25,000). Although not a perfect hedge (23,000 bushels vs. the hedged 25,000 bushels) the farmer had the benefit of liquidity should he decide to get out of it.
The exchange also created the concept of the clearing firm. A clearing firm always takes the other side. It eliminates credit risk by requiring both parties to post and maintain certain margin requirements.
Another benefit was that the exchanges clearing firm took the other side of the trade therefore eliminating credit risk. In a forward contract if the other party doesn't fulfill his side of the bargain or goes bankrupt well too bad.
CONTINUE... TO THE BASICS OF TRADING FUTURES MARKETS PART 2
* Some information is compiled from public sources and believed to be reliable but is not guaranteed as to its accuracy or completeness. No responsibility is assumed for the use of this material and no express or implied warranties are made. Nothing contained herein shall be construed as an offer to buy/sell, or as a solicitation to buy/sell, any security, commodity or derivatives instrument. Instruments such as Futures, Forex, Options, and CFD trading involve a substantial risk of loss and is not suitable for all investors. Please carefully consider your financial condition prior to making any investments.
