Futures contract Definition: In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized

quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short". The terminology reflects the expectations of the parties -- the buyer hopes or expects that the asset price is going to increase, while the seller hopes or expects that it will decrease. Note that the contract itself costs nothing to enter; the buy/sell terminology is a linguistic convenience reflecting the position each party is taking (long or short).In many cases, the underlying asset to a futures contract may not be traditional commodities at all that is, for financial futures the underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. Unlike an option, both parties of a futures contract must fulfill the contract on the delivery date. The seller delivers the underlying asset to the buyer, or, if it is a cash-settled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position can close out its contract obligations by taking the opposite position on another futures contract on the same asset and settlement date. The difference in futures prices is then a profit or loss. Futures versus forwards While futures and forward contracts are both contracts to deliver an asset on a future date at a prearranged price, they are different in two main respects: Futures are exchange-traded, while forwards are traded over-the-counter.

A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; an exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on

the exchange must be well standardized to transparent trading. Non-standard products are traded in the so-called over-the-counter (OTC) derivatives markets. OTC derivatives have less standard structure and are traded bilaterally (between two parties). In such bilateral contract, each party should have credit risk concerns with respect to the other party. OTC derivatives are significant in the asset classes such as interest rate, foreign exchange, equities and commodities. Over-the-counter (OTC) or off-exchange trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via facilities constructed for the purpose of trading (i.e. exchanges), such as futures exchanges or stock exchanges

Thus futures are standardized and face an exchange, while forwards are customized and face non-exchange counterparty. Futures are margined, while forwards are not.

While the futures contract specifies a trade taking place in the future, the purpose of the futures exchange institution is to act as intermediary and minimize the risk of default by either party. Thus the exchange requires both parties to put up an initial amount of cash, the margin. Additionally, since the futures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange will draw 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, then a margin call is made and the account owner must replenish the margin account. This process is known as marking to market. Thus on the delivery date, the amount exchanged is not the specified price on the contract but the spot value (since any gain or loss has already been previously settled by marking to market). Thus futures have significantly less credit risk, and have different funding.

Exchange versus OTC Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties. Thus: Futures are highly standardized, being exchange-traded, whereas forwards can be unique,

being over-the-counter. In the case of physical delivery, the forward contract specifies to whom to make the

delivery. The counterparty for delivery on a futures contract is chosen by the clearing house.

A closely related contract is a forward contract. A forward is like a futures in that it specifies the exchange of goods for a specified price at a specified future date. However, a forward is not traded on an exchange and thus does not have the interim partial payments due to marking to market. Nor is the contract standardized, as on the exchange.

Forward contract

Definition:

A forward contract on an asset is an agreement between the buyer and seller to exchange cash for the asset at a predetermined price (the forward price) at a predetermined date (the settlement date). The asset underlying a forward contract is often referred to as the $underlying# and its current price is referred to as the $spot# price. The buyer of the forward contract agrees today to buy the asset on the settlement date at the forward price. The seller agrees today to sell the asset at that price on that date. No money changes hands until the settlement date. In fact, the forward price is set so that neither party needs to be paid any money today to enter into the agreement.

Example: Foreign Exchange (FX) Rates:

1. Yen / dollar transactions For immediate delivery: 0.007927 $/ For delivery in six months: 0.008150 $/ Example Suppose that we need 10 Million in six months (the maturity date). We can:

(a) Wait and gamble on what the exchange rate will be then. (b) Buy yen today and invest them until maturity. (c) Buy yen forward. No money changes hands today.

At maturity, we pay 10 Million(.008150 $/) = $81,500; receive 10 Million. Foundations of Finance: Forwards and Futures

2. Hedging and speculation

a. The need for 10 Million is an obligation that exposes us to exchange risk. Buying forward hedges this risk. If we did not have any need for yen, the transaction to buy yen forward would represent a speculative bet that the yen would rise relative to the dollar: If at maturity, the exchange rate is 0.010000 $/, resell the for $: 10 Million 0.010000 $/ = $100,000, Profit = $100,000- $81,500 = $18,500 If at maturity, the exchange rate is 0.007000 $/, We get: 10 Million 0.007000 $/ = $70,000, Profit = $70,000- $81,500 = -$11,500 b. Hedging means removing risk. It does not mean guaranteeing the best possible outcome (If at maturity the exchange rate is 0.007000 $/ the hedger will regret having locked in the worse rate.) A forward contract is not an option. The buyer must go through with the contract, even if the spot rate at maturity is worse than agreed upon. No money changes hands until maturity. (There is nothing corresponding to the option premium.)

3. Transactions from the perspective Suppose a Japanese firm needs $ in 6 months. They face the opposite problem and can buy $ forward. Such a firm might be the counterparty to the U.S. firms forward transaction. (In general, either or both sides might be hedger or speculator). Again, note that: One does not buy a forward contract (no money is exchanged today for a financial asset) One enters into a forward contract: buys yen forward or sells dollars forward

For everyone who has sold the dollar forward (against the yen), there is someone who has bought the dollar forward (against the yen) (like zero net supply in options) If one side of the forward contract has a profit (relative to the subsequent spot price), then the other side has a loss (like zero-sum game in options).

Hence, In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today.[1] This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into. The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.