Futures and Forwards
Welcome back. Today, we’ll be discussing two financial instruments that are integral to capital markets but are grossly misunderstood from the general public: forwards and futures.
Don’t let these names intimidate you; they are quite simple in theory and can greatly enhance your understanding of financial news and future economic outlook. In today’s lesson, we’ll discuss the fundamental principle behind futures and forwards and what distinguishes them, as well as their basis as economic indicators.
Let’s begin with futures. A future is a financial instrument in which two parties agree to trade a certain good or product at a future date for a set price. Its main purpose is to hedge (i.e. reduce) risks associated with certain business. An example may help clarify this concept.
Suppose you are the risk management team at Airline XYZ. You are assessing oil and fuel prices over the next six months and are unsure of whether prices will go up or down. Since fuel is a large expense for your airline, you decide to hedge it, thus removing its risk. Assuming oil is currently trading at $50/barrel and you expect it to increase, you purchase a future for $55/barrel. If the price of oil goes up to $75/barrel, you are still buying it at $55. However, if the price of oil decreases to $45, you suffer.
This example demonstrates the main purpose of futures: hedging—minimizing the risk of a loss by locking in a price. Another common use of futures is for speculating—predicting future increases and decreases in the market and using financial tools to benefit from such anticipated changes.
Forwards vs. Futures
Forwards are based on the same concept as futures, except they are less standardized, meaning they are not traded on an exchange. The benefit of futures is that since they are higher in volume and more liquid, it is easy to find a counterparty to buy or sell the opposite side of your trade. However, they tend to be rather generic with the underlying assets they cover (e.g. oil).
Forwards, however, are highly customizable and can be based on any imaginable asset, such as the weather, a sporting event, or the price of corn, and for any time period and price, provided you find an investor willing to take the opposite side of such a trade.
When listening to business news, you’ll frequently hear economists and financial experts discuss the price of futures on commodities. This is due to futures being utilized as economic indicators of future market fluctuations. When we expect oil prices or currencies to go up, this indicates a bullish outlook—expecting the economy to boom. Similarly, when futures prices are depressed, it indicates a bearish outlook and a decrease in economic output.
As we finish our introduction to futures and forwards, tomorrow, we’ll cover options: a financial instrument similar to futures and used to hedge against fluctuations.
For more information on futures and forwards, I highly recommend the Khan Academy videos.
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