Sunday, August 17, 2008

forward contract^futures contract

a futures contract == a standardized forward contract guaranteed by an exchange, just as
a listed option == a standardized version of an OTC option

I feel we should first understand commodity forward contracts first. Commodity futures are the simplest and earliest form of futures. Forward contract is the foundation of futures; futures contracts form a foundation for IRS, swaption and other derivatives.

Note the fundamental entity (or tradable instrument) is the contract. A forward corn contract is nothing but a spot corn contract with a future delivery date. Note price is fixed at the transaction time, otherwise there's no contract, no agreement, no obligation.

In mid 1997 i took short positions on copper futures market, agreeing to sell (for a future date) at relatively low delivery prices (say $121k) and lost badly when prices rose. I had to cover the short by entering a long position (say 131k). Counter party to every contract is always the Exchange. Effectively, i agreed with Exchange to sell to Exchange at 121k and buy at 131k for the same quantity of copper for the same delivery date. When I entered each position some sum was frozen in my margin account. Since my 2 positions cancelled out and $10k was permanently frozen (actually transferred out). Exchange or the broker allowed me to close my margin account.

This is a forward contract, but traded on the exchange.

http://thismatter.com/money/forex/fx_forwards.htm says

"FX futures are basically standardized forward contracts. Forwards are contracts that are individually negotiated and traded over the counter, whereas futures are standardized contracts trading on organized exchanges. Most forwards are used for hedging exchange risk and end in the actual delivery of the currency, whereas most positions in futures are closed out before the delivery date"

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