Most basically, forward and futures contracts; It allows traders, investors and commodity producers to speculate on the future price of an asset. These contracts function as bilateral commitments to trade an instrument at a future date (expiration date) at the price agreed upon at the time the contract was created.
The financial instrument underlying call and forward contracts; It can be any asset such as stocks, commodities, currencies, interest payments or even bonds.
But unlike forward contracts, forward contracts are standardized from a contractual point of view (as legal agreements) and are traded in specific venues (futures exchanges). Therefore, forward contracts are subject to certain rules. These rules may include, for example, the size of the contract and daily interest rates. In most cases, the execution of the forward contract is guaranteed by a clearing house, allowing parties to trade with less counterparty risk.
Although primitive versions of futures markets were created in Europe in the 17th century, the Dōjima Rice Exchange (Japan) is considered the first established futures exchange. In early 18th century Japan, most payments were made in rice, so forward contracts were introduced to hedge the risks associated with fluctuating rice prices.
With the emergence of electronic trading systems, futures contracts have become widely used throughout the financial industry with different usage areas.
Functions of forward contracts
In the context of the financial industry, futures contracts typically perform the following functions:
Hedging and risk management: Futures contracts can be used to reduce a certain risk. For example, a farmer may sell his crops on a forward contract to ensure that he receives a certain price in the future despite unfortunate events and market fluctuations. Or a Japanese investor who owns a US treasury bill can hedge the USD impact by purchasing a JPYUSD futures contract for an amount equal to the quarterly coupon payment (interest rate), thus locking the value of the coupon in JPY at a certain rate in advance.
Leverage: futures contracts allow investors to create leveraged positions. When agreeing on a maturity date for contracts, investors can use leverage for their positions. For example, 3:1 leverage allows traders to enter positions three times the size of their trading account balance.
Short-term risk: futures contracts allow investors to take short-term risk on an asset. If an investor decides to sell a futures contract without owning the underlying asset, this is often called an unsecured position.
Asset diversification: investors can take exposure to assets that are difficult to spot trade. Shipping commodities such as oil is often costly and involves high storage costs. But by using futures contracts, investors and traders can speculate on a wide variety of commodities without physically executing the trade.
Price discovery: futures markets are a one-stop shop for buyers and sellers of various types of assets such as commodities (i.e. supply and demand combine). For example, oil prices may be determined in futures markets based on real-time demand prices in futures markets, rather than through local interactions at gas stations. In addition, futures contracts are often traded outside daily trading hours, which makes prices more transparent.
Reconciliation mechanisms
The maturity date of a forward contract is the day on which the last trading activity for this contract can be carried out. After this day, trade ends and contracts are agreed upon. There are two primary mechanisms for forward contract settlement.
Physical settlement: the underlying asset is exchanged between two parties who have previously agreed to a contract at a certain price. The short (selling) party has the responsibility to deliver the asset to the long (buying) party.
Cash settlement: the underlying asset is not exchanged directly. Instead, one party pays the other party a payment equivalent to the current value of the asset. One of the typical examples of cash-settled futures contracts is oil futures contracts. Since it would be quite complicated to physically trade thousands of barrels, they are traded in cash.
Cash-settled futures contracts are easier to execute and are therefore more commonly used even for liquid securities or fixed income instruments whose ownership can change hands fairly quickly (at least compared to physical assets such as barrels of oil).
However, cash-settled futures contracts may cause manipulation of the price of the underlying asset. This type of market manipulation is often referred to as “banging the close,” which describes abnormal trading activities intended to disrupt order books as futures contracts approach maturity dates.
Exit strategies from forward contracts
Once a futures contract position is taken, there are three basic actions futures traders can take:
Reverse transaction: is the name given to the act of closing a futures contract by creating a counter transaction of equivalent value. So if a trader owns 50 futures contracts with a short position, he can neutralize his initial position by opening an equal amount of long positions. The reversal trading strategy allows traders to realize their profits and losses before the settlement date.
Position rollover: It occurs when a trader decides to open a new futures contract after the offset of his first futures contract and basically means extending the maturity period. For example, if a trader has 30 long positions in a futures contract due the first week of January but wants to extend his position for six months, he can open an equal size position with a futures contract of the first week of July, offsetting his initial position.
Settlement: If a trader holding a futures contract does not renew his position or take a reverse trade, the contract is settled on the maturity date. At this point, the parties involved are legally required to exchange assets (or cash) based on their positions.
Futures contract price structures: contango and normal depor
From the moment forward contracts are created until agreement is reached, contract market prices are constantly changing depending on buying and selling powers.
The relationship between the changing prices of maturity and futures contracts creates different price structures. These are generally called contango (1) and normal depor (3). As shown in the chart below, these price structures are directly linked to the expected spot price (2) of an asset at maturity date (4).
Contango (1): a market condition in which the futures contract price is higher than the expected futures spot price.
Expected spot price (2): the expected price of the asset at the time of settlement (maturity date). It should be noted that the expected spot price is not always fixed. For example, it may vary depending on market supply and demand.
Normal depor (backwardation) (3): a market condition in which the forward contract price is lower than the expected futures spot price
Expiration date (4): the last day of trading for a futures contract before settlement is reached.
While contango market conditions are more profitable for sellers (short positions) than for buyers (long positions), normal tank markets are generally profitable for buyers.
As the maturity date approaches, it is expected that the futures contract price will gradually approach the spot price and eventually the two will meet at the same value. If a futures contract and spot price are not the same on the expiration date, traders can make a quick profit through arbitrage opportunities.
In a contango scenario, futures contracts are generally traded at a price higher than the expected spot price for convenience. For example, a futures trader may decide to pay a premium for a physical commodity to be delivered at a future date, so that he or she does not have to think about things like storage and insurance costs (gold is a common example). Additionally, companies can use forward contracts to lock in future expenses at predictable values by purchasing commodities essential to their services (such as a bread manufacturer purchasing a wheat futures contract).
A normal warehouse market, on the other hand, occurs when futures contracts trade below the expected spot price. Speculators buy futures contracts in the hope of making a profit if prices rise as expected. For example, a futures trader might purchase barrels of oil for $30 apiece today with an expected spot price of $45 next year.
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As a standard type of exchange contracts, forward contracts are one of the most used instruments within the financial industry, and their diverse functionality makes them suitable for many uses. However, before investing in funds, it is very important to understand the underlying mechanisms of futures contracts and their markets.
While locking in the price of an asset into the future can be useful in certain situations, it is not always safe, especially if contracts are traded on margin. Therefore, risk management strategies are often used to limit the risks that are inevitable in futures contract trading. Some speculators use technical analysis indicators as well as fundamental analysis to get an idea about the price movements of futures markets.
