Future and Forward Contracts

A forward  or a future is a financial contract obligating a  buyer to purchase  an asset or the seller to sell an asset at a predetermined future date and price.The asset being bought and sold can be a physical commodity or a financial instrument.Some forwards contracts may call for physical delivery of the asset but most of them are settled in cash. The forward has two purposes they are the hedging and speculative purpose.
Alex owns a iron mine and he is worried about  the prices falling in the next 2 months and Toyota,a car manufacturer uses a lot of iron and  is worried about the price rising of iron in the 2 few months.Alex can now enter into a forwards contract with Toyota to sell a definite quantity of iron at a fixed but a reasonable rate .On maturity of that date Alex sends over the predetermined price of iron and Toyota pays the amount to Alex closing the contract.

Here both Alex and Toyota have successfully hedged their risks.Alex would be in a trouble if the prices were to plunge and Toyota would suffer if the prices rose so both of them using a forwards contract have reduced the risk borne by them to another person.In this contract both parties cant win and one stands to lose.If the market prices were lower than the agreed prices then Toyota would lose money and if the prices were higher Alex would suffer.

Avi and Mustafa are two speculator and want to earn money in the forward market. Avi  predicted that the price of the gold would fall. Mustafa on the other hand thought that the prices would rise because of increased demands so he entered into a futures contract with Avi.He agrees to but the gold from Avi at INR 1,00,000 whatever the market price might be and Avi to sell at the quoted price in the next month.Now,if the prices increase to INR 1,20,000 then Avi is in a loss and need to either by gold at the market price and sell at agreed price  to settle the contract,but if the prices were to fall to say INR 70,000 then Avi could buy gold at that price and sell it to Mustafa at INR 1,00,000 as per the agreement.

In cases they don,t want any possession of goods then Avi can simply pay Mustafa INR 20,000 in the first case as it the amount he actually earns and in the second case Mustafa should pay Avi INR 30,000 to execute the contract.
Forward and Futures contracts are quite similar in nature as both of the contracts allow people to buy or sell a specific type of asset at a specified time at a fixed price.The major difference between the two is that future contracts are exchange traded and therefore are standardized.Forward contracts on the other hand are private agreements between two parties and aren’t that rigid in their stated terms and conditions and as they are private agreements there is always a chance that a party may default on its side of the agreement. Future contracts have drastically lower chances of default as they are quiet well regulated.Forward contracts are usually  settled at the end of the time period whereas  futures contracts are marked to market daily which means that changes in price occurring at each particular day are settled day by day until the end of the contract.Forwards and futures are basically the same except for the exchange traded and daily settlement feature.

Futures and forwards are a type of derivatives which are basically used for speculative and hedging purpose and can act as a good source of earnings provided that can make correct decisions and decide the future trend in the economy.Many banks and other financial institutes take active participation in these type of contracts.

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