Forward and future contracts on commodities are financial agreements between two parties to buy or sell a specific quantity of a commodity at a predetermined price on a specified future date. These contracts are used for various purposes, including hedging against price fluctuations, speculating on future price movements, and facilitating trade in commodity markets.
Both forward and futures contracts on commodities serve important functions in the global economy. They allow producers and consumers to manage price risk, provide investors with opportunities for speculation, and facilitate the efficient functioning of commodity markets. Traders and market participants choose between forwards and futures based on their specific needs, risk tolerance, and preferences for customization versus standardization.
Forward Contracts on Commodities:
Forward contracts are private agreements tailored to the specific needs of the parties involved. The terms, including the commodity, quantity, price, and delivery date, are negotiated between the buyer and seller.
Over–the–Counter (OTC) Market:
Forward contracts are traded in the over-the-counter market, which means they are not standardized and do not go through a centralized exchange. This allows for flexibility but also exposes participants to counterparty risk.
Since forward contracts are private agreements, there is a risk of default by one of the parties. This risk is mitigated through due diligence and possibly the use of collateral.
There is typically no daily adjustment of the contract’s value. The profit or loss is realized only at the contract’s maturity.
Delivery vs. Cash Settlement:
Forward contracts can result in physical delivery of the commodity or cash settlement, depending on the terms agreed upon.
Futures Contracts on Commodities:
Futures contracts are standardized agreements with fixed contract sizes, expiration dates, and contract terms. They are traded on organized exchanges.
Futures contracts are traded on regulated exchanges, providing a centralized marketplace with transparent pricing and reduced counterparty risk. The exchange acts as an intermediary, guaranteeing the performance of the contract.
Futures contracts are subject to daily marking-to-market, where the contract’s value is adjusted based on the current market price of the commodity. This minimizes counterparty risk and ensures transparency.
Liquidity and Transparency:
Futures markets are highly liquid, allowing for easy entry and exit. Additionally, prices and trading activity are publicly available, providing transparency to all market participants.
Variety of Commodities:
Futures contracts cover a wide range of commodities, including agricultural products, energy resources, metals, and financial instruments linked to commodities.
Traders are required to deposit an initial margin with the exchange to open a futures position. Maintenance margins may also be required to cover potential losses.