A forward contract is an agreement to buy or sell an asset at a certain future time for a certain price. It can be contrasted with a spot contract, which is an agreement to buy or sell an asset today.
A forward contract is traded in the over-the-counter (OTC) market, usually between two financial institutions or between a financial institution and one of its clients. However, this also means it is more difficult to reverse a position, as the counterparty must agree to cancel the contract. This also increases credit risk for both parties.
Forward contracts ability to lock in a purchase or sale price without incurring much direct cost makes it attractive for hedging as well as speculation.
A example would help illustrate the mechanics of a forward contract. Suppose on January 1, 2012 an Indian textile exporter receives an order to supply his product to a big retail chain in the US. Spot price of INR/US exchange rate is Rs 45/dollar.
After six months, the exporter will receive $1 million (Rs 4.5 crore) for his products. Since all his expenditure is in rupee term therefore he is exposed to currency risk. Let’s assume that his cost of production is Rs 4 crore. To avoid uncertainty, the exporter enters into a six-month forward contract with a bank (with some fees) at Rs 45 to a dollar. So the exporter is hedged completely.
If exchange rate appreciates to Rs 35 after six months, then the exporter will receive Rs 3.5 crore after converting his $1 million and the rest Rs 1 crore will be provided by the bank. If exchange rate depreciates to Rs 60/dollar then the exporter will receive Rs 6 crore after conversion, but has to pay Rs 1.5 crore to the bank. So no matter what the situation, the exporter will end up with Rs 4.5 crore.
The only risk exporter faces is counterparty risk (what if the bank or the retail chain goes bankrupt).
Futures contract are very similar to forward contract except they are exchange traded, or defined on standardised assets. The futures markets are characterised by the ability to use very high leverage relative to the stock market.
Futures can be used either to hedge or to speculate on the price movement of the underlying asset. For example, a producer of oil could use futures to lock in a certain price and reduce risk (hedge). On the other hand, anybody could speculate on the price movement of oil by going long or short using futures. In reality, delivery of the underlying goods specified in futures contract is very low.
This is because the hedging or speculating benefits of the contracts can be had largely without holding the contract until expiry. For example, if you were long in a futures contract, you could go short on the same type of contract to offset and exit the position. This is similar to selling a stock you purchased in the equity market.
The mechanics of a futures contract is similar to forward contract described earlier. The only difference is that you can easily close your position anytime during the time of the contract.
Counterparty risk is also reduced, since both the parties have to provide margin to the exchange in which the trade has been done.