Futures vs Forward Contracts
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Futures Contracts commonly known as futures are also financial derivatives constituting an instrument for hedging the risk in the financial markets due to the price fluctuation of the assets. The features of a futures contract are the same as that of a forward contract. However, these are two different instruments used for risk management. Futures contracts have been designed to remove the disadvantages of forwarding contracts. A futures contract can be defined as an agreement between two parties for buying or selling an asset at a certain time in the future at a certain price. Like commodities, financial assets form the underlying assets in futures contracts. So, Stocks, bonds etc. are the financial assets underlying futures contracts. A futures contract on financial assets is known as financial future. The fundamental idea regarding futures contracts is that for hedging a portfolio with higher volatility than the market index, more futures contracts may be required to bring about an effective and efficient hedge. Futures vs Forward Contracts.
The required number of futures contracts can be estimated by using the following formula:
F0 = [Vp/ Vf] × βp
Where,
F0 = Required number of futures,
Vp = Value of portfolio to be hedged,
Vf = Value of one futures contract,
βp = Portfolio beta
Forward contracts are commitments entered into by two parties to exchange a specific amount of money for a particular commodity at a specified future time. A forward contract can be described as an agreement to buy or sell an asset at a predetermined fixed price at a specified future date. In a forward contract, the agreement is initiated at one time but the execution of the contract takes place at a subsequent date. The terms of the contract, such as price, quality and quantity of the assets, delivery date are specified at the time of initiating the contract but the actual payment and delivery of the asset occur later. Futures vs Forward Contracts.
Under a forward contract, one of the parties of the contract agrees to buy the underlying asset on a certain specified future date at a certain price. The other party of the contract agrees to sell the underlying asset on the same day at the same price.
The following terms are applicable in a forward contract:
The buyer of such a contract is said to have a long position while the seller has a short position.
The price specified in the forward contract is termed as the delivery price and the time specified is referred to as delivery date.
