Suppose a farmer grows tomatoes and enters into a contract to supply 5000 kg of tomatoes to the ketchup factory which is situated far away. The ketchup factory arranges to pick up the tomatoes from the farm and transports them to the factory directly. The tomatoes are supplied at the market prices prevailing on the date of supply. Having said that, both the farmer and the ketchup factory has to face the price risk as neither of them was sure about the prevailing market prices on the day of supply. This is where a basic forward contract comes into picture.
A forward contract is an agreement between a buyer and seller wherein an asset is traded at a future date. Settlement of the price of the asset is done when the contract is drawn up. Forward contracts are settled at a particular date at the end of the contract. These contracts are not traded on an exchange as these are private agreements between two parties. Because of the nature of the contract, these aren’t as rigid in their terms and conditions.
Going back to the above example, the farmer needs a minimum price of Rs.30 per kg to cover his costs and make a profit. So he wishes to sell tomatoes to the ketchup factory at a minimum price of Rs.30 per kg exactly 3 months from now. But the Ketchup factory can buy tomatoes from the farmer at Rs.33 per kg at the end of 3 months. At this price, the ketchup factory can cover all its costs including transportation and also make a margin.
A 3-months forward contract is initiated under which the farmer will supply 5000 kg of tomatoes to the ketchup factory at the end of the 3 month period at a price of Rs.31.5 per kg. Both the parties can be benefitted at this price. For the farmer it is Rs.1.5 better than the minimum price that he is expecting to be profitable in the market. Whereas, for the ketchup factory it is Rs.1.5 lower than the cost at which the factory can be profitable.
There can be three possibilities on the date of maturity of the forward contract
The price of tomatoes in the market on the maturity date may be Rs.31.5. In this case, both the parties will fulfill their obligations and execute the contract.
The price of tomatoes may fall. Say, the price is Rs.27. Under this forward contract, the farmer will make a profit of Rs.4.5 per kg as he will get Rs.31.5 per kg instead of the market price of Rs.27. However, the ketchup factory will be in a loss as they have to honour their part of the forward contract at Rs.31.5, when they could have bought it in the open market at Rs.27.
The price of tomatoes may rise. Say, the price is Rs.35. Now the farmer makes notional loss of Rs.3.5 per kg as he will get only Rs.31.5 per kg instead of the market price of Rs.35. Whereas, the ketchup factory can procure the tomatoes at Rs.31.5, for which they would have had to otherwise pay Rs.35 per kg.
It is important to note here that although the forward contract is the right and the obligation for the parties, the profits or losses can also be unlimited to both. But it gives a degree of certainty to the farmer and the ketchup factory. The farmer gets assurance of his income irrespective of market conditions and the ketchup factory knows its costs of procurement and can plan its budgets accordingly.
Forward contracts do sound good, but there are a lot practical difficulties. What if any of the party is unable to honour their side of the contract? The default may be intended or unintended. Either ways, the other party will be put through a lot of trouble. Of course, forward contracts are regulated under the Contracts Act and hence the contract can be enforced in the court of law. But, that is a very long and cumbersome process and the parties to a forward contract may have neither the time nor the resources to pursue prolonged legal recourse.
There may also be a case where either of the party wants to exit the contract midway for some genuine reasons. After entering into a forward contract, parties are under an obligation and cannot exit the contract. They can do so if they are able to find another similar party who is willing to honour the contract on their behalf. Forward contracts tend to become illiquid due to their uniqueness to specific circumstances. It is to address these problems that the concept of futures transaction comes into play.
Just like forwards, futures contracts involve an agreement to buy and sell an asset at a specific price at a future date. But the two aren’t exactly the same.
Futures contracts are marked-to-market daily. Daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of future dates.
As futures are traded on an exchange, they have clearing houses that guarantee the transactions. This lowers the probability of default. Future contracts are available on stock exchange indexes, commodities and currencies. Crops such as wheat and maize, and oil and gas are the most popular assets for future contracts. The market for such contracts being highly liquid gives an option to the investors to enter and exit at their own will.
These contracts are often used by speculators who bet the price movement of an asset. Such contracts are closed before maturity and generally never delivered. There is usually a cash settlement in this case.
To sum up, forwards are private contracts so they work on good faith. However, when you enter into an exchange-traded futures contract, you get a real idea of the costs. There is a margin that the exchange collects in advance when you enter into a future contract. The exchange margins are defined as the initial margins consisting of the VAR margin and the extreme loss margins. In addition, if prices move against the Party, the exchange also collects mark-to-market margins (MTM). Whether you are a buyer or a seller in a future contract, the initial margins are similar. Only the MTM margins vary depending on which side of the contract you are on.