Forwards & Future

Types and Characteristics of Derivative Securities
Derivative securities are contracts that derive their value from some other thing, known as the underlying instrument. Derivatives include warrants, options, futures, and forwards. The underlying instruments whose value drives the derivatives' value could be common stock or stock indexes, interest rates, or agricultural commodities such as corn and soy beans.

A futures contract is a binding agreement between two parties that obligates the two sides to buy and sell something for a set price, with delivery occurring at a specified future date. In the world of commodities including corn, orange juice, and crude oil there is today's cash price known as the spot price. And then, there is the futures price specifying what the commodity can be bought or sold for as of some future delivery date. Will the price of corn, orange juice or crude oil rise above or fall below that futures price by next December? That is why they open the markets for trading every day.
A grain farmer typically does not wait to harvest 1,000 acres of corn and soybeans in the fall and then see how much the cash or spot price might be at that point. With futures contracts the farmer can sell some corn and soybean futures to buyers who want to lock in a purchase price now for delivery, say, next November. The farmer, this way, can lock in a minimum price he'll receive for some of his corn and beans in case crop prices drop by the time he harvests them. And the buyers who need his corn and beans can lock in a maximum purchase price on what they need to buy in the near future.

Those who use futures to lock in purchase or sale prices related to their businesses are called hedgers. Those who use futures to bet on the near-term price movement of a commodity are called speculators. Common commodities traded include, corn, soy¬beans, crude oil, live cattle, sugar, and cocoa, to name just a few.

If a farmer is producing corn, and a cereal maker needs to buy corn, the farmer can sell some of his crop even before it's harvested, while the cereal maker can lock in a maximum price for corn set for delivery as of a certain month. In this case, the farmer producing the commodity is short, while the cereal producer is long in the futures contract.

Long positions profit when the price of the commodity rises, while short positions profit when the price of the commodity drops, just as they do with options and common stock. What the two sides are doing, then, is identifying their risk and betting that way. The cereal producer is hurt if the price of the commodities they need rises. Therefore, they bet that way and profit if their risk materializes.

The farmer can't take the chance that all his grain will be sold at depressed prices in the future; therefore, he sells some contracts now representing what could end up being the highest price for delivery the market sees for years. In other words, he'll be glad he sold the corn at $12 a bushel back then if it ends up being worth only $3.50 on the spot market by the time it's harvested.

Futures contracts are standardized by the exchange where they trade. That means the quantity, the quality, and the delivery are all standard terms so the prices of the commodities traded mean the same thing to everyone in the market. For example, the quality specifications of each type of crude oil traded are standardized so "light sweet crude" is the same no matter who produces it. As of this writing, the standard terms of coffee futures involve 37,500 pounds of coffee per contract with expiration months in March, May, July, September, and December. Corn futures contracts cover 5,000 bushels each, expressed as a price per-bushel with a minimum "tick size" of 1/4 of 1 cent per bushel.

Most options contracts that are near- or in-the-money are closed out before expiration because the buyer of a call option that goes in the money, for example, doesn't want to come up with the cash to buy the stock at the strike price any more than the seller wants to go buy the stock and deliver it.

With futures, all buyers and sellers need to reverse/offset their contracts before expiration to avoid making or accepting delivery of grain, live cattle, or light sweet crude, etc. With futures both sides are obligated to perform the contract if they're holding at expiration. Of course, speculators and hedgers go through brokers, who remind their customers with open long or short positions to close them out before expiration, just as my broker-dealer does for everyone trading options. Even if a retail investor forgot to liquidate a contract to buy 400,000 pounds of live hogs, he would not see a semi-truck pull up to his front door the next day. Rather, he would receive a receipt good for 400,000 pounds of live hogs. Even the hedgers typically liquidate their futures contracts rather than taking delivery of corn, soybeans, etc.

These days the underlying instrument for futures contracts is not just the raw materials/commodities used to produce other products. Stock indexes, interest rates, currencies, and other financially based instruments are used to create financial futures. For example, rather than trading S&P 500 index options, a speculator could trade the S&P 500 futures contracts, e.g., the E-Mini S&P and the E-Mini NASDAQ:100. Or, he could speculate on interest rate movements or foreign currency values. There are even contracts for emissions credits, weather, and band with available.

As with all derivatives, futures are a "zero-sum game," meaning if one side makes $30,000 it's because the other side lost $30,000. The contracts are also sometimes called "wasting assets," along with options. That is somewhat different from common stock, where one investor can earn dividends over time and sell the stock to someone else, who might end up doing the same before passing it on to another investor. Also, futures give traders leverage, putting them at risk without having to put down much of their own money initially.

Options, on the other hand, are paid in full. If you buy 3 ORCL Oct 40 calls @2, you must pay the full $600 upfront (3 times the $200 represented by the "@2").
Not so with futures. A futures contract is not something you buy or sell, really. Rather, both sides agree to the daily margin settlement that will occur as the price of the commodity moves day by day. The futures exchange requires both parties to put up an initial amount of cash, called either margin or a good faith deposit usually between 5 and 15% of the contract value. Then, since the futures price will change daily, the difference in the strike price and the daily futures price is settled daily also.

On the other hand, if you buy those ORCL Oct 40 calls for $2 a share, you don't lose anything right now if they start trading for, say, $1 a share. I mean, it stinks, but until the contract expires, it's just a "paper loss" when you're trading options. However, with futures the exchange will pull money out of one party's margin account and put it into the other's so that each party has the appropriate daily loss or profit. If the margin account goes below a certain value, a margin call is made and the account owner must deposit more margin to keep the game going. This process of recalculating values daily is known as marking to market, just as it's called in a margin account for stocks and bonds.

When you buy an option, you can only lose what you pay. For example, no matter how far ORCL drops, you can only lose the $2-per-share premium. With a long futures position, however, you would continue to lose as the price of the commodity continues to drop.

As with options, the buyer would only pay the contract price and the seller receive it upon delivery. But, as with options, most futures contracts do not lead to delivery. Futures traders offset (reverse) their trades before settlement to avoid having to provide or accept delivery of the actual commodity itself. Maybe 1% of all contracts lead to delivery of the underlying commodity.

A forward is like a futures contract in that it is a derivative that specifies a price for something for delivery at a specified future date. However, a forward is not traded on an exchange. Also, forward contracts are not standardized the way options and futures contracts are standardized by the exchanges on which they trade. On the options and futures exchanges, we find clearinghouses, which act as a buffer between every buyer and seller. I mean how do you know for sure the other side can deliver 100,000 shares of ORCL or a million barrels of light sweet crude? You don't, but luckily the options and futures exchanges have all the buyers and sellers going through clearinghouses, which guarantee the performance of every contract, period.

So, forwards are side deals between two parties. How do you know the other side is good for the contract if there's no exchange enforcing margin requirements, settle¬ment dates, and guaranteeing all contracts are good?

That's the counter party risk that forwards present to both sides of the contract. On a regulated exchange, options and futures traders do not have to worry about the financial strength of the other side of the contract. The advantage of trading in forwards is the flexibility they allow both sides of the contract the expiration date, the size of the contract, the terms of the contract, etc., are up to the two parties as opposed to the standardized contracts available on the commodity futures and options exchanges. Some companies have a specific need for a type of derivative that may not be offered on the options or futures exchanges. In that case, they may want to structure a private derivative contract with another party called a "forward."


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