Part 2: Futures Contracts
The first article of this series illustrated the basics of forward contracts. In this article we will discuss futures contracts and the differences between the two.
A futures contract, unlike the privately-traded forward contract, is publicly traded. As with the forward, each futures contract is for the purchase or sale of a loan, currency or commodity with actual delivery scheduled to occur at some time in the future. While the concept behind both forwards and futures contracts is the same -- namely, providing a way for buyers and sellers to lock in a price today for transactions that will take place in the future -- the way in which they are implemented is, for the most part, completely opposite.
While forward contracts are privately executed between two parties who know each other (at least figuratively speaking), futures contracts trade on the floor of a futures exchange. And because they trade on the floor of an exchange, the transactions are always handled by brokers who are members of that exchange. No futures contracts are executed by the parties themselves, thereby maintaining anonymity throughout the process. For example when someone buys pork bellies or U.S. T-bills via a futures contract, they have no idea whom they are actually buying them from, which brings up the subject of risk.
The only reason that people are willing to buy and sell futures contracts with anonymous counter parties is that the exchange which facilitates the transaction guarantees all trades. So, unlike forward contracts, where each side is exposed to the credit risk of its counter party, with futures, the exchange assumes the credit risk if a party defaults on its obligations. The exchanges are, in turn, backed by insurance policies, lines of credit, and the financial strength of their members. This makes them, for all intents and purposes, free of any credit risk. The exchanges significantly reduce the amount of risk to which they themselves are exposed by setting forth strict rules concerning the counter parties and contracts in which they deal. For example, customers who buy and sell futures contracts are required to post a security deposit, known as a margin, against their market position. They are also required to cover their losses on a daily basis, which is commonly referred to as being “marked to the market”. Additionally, exchanges demand that delivery of the underlying instrument at the expiration of the contract be done at the then current spot price.
The fact that delivery occurs at the spot price has two very important effects on the futures market: first, it removes any incentive for either party to default on the contract when the time for delivery arrives. The spot price and the price that the exchange pays are the same, so neither buyer nor seller can gain an advantage by dealing with a source other than the exchange (which would raise further credit risks for the parties anyway). It also removes any incentive for either party to actually go through with the delivery procedure. (One of the major advantages of futures is that neither side has to hold onto its position until contract expiration.) Because all profits and losses associated with the transaction are already recorded in each party’s margin account (remember that they’re “marked to the market”), most futures contracts are closed out in advance. Only a very small percentage of them ever actually go to delivery.