Commodity Trading: Forwards and Futures

Commodity Trading

With forwards and futures, agreements are usually made to receive the commodities at a future date for a predetermined consideration based on agreed-upon terms. Forwards and futures diminish the risks by permitting the trader to settle on a price at the time of the transaction for goods to be transferred and delivered on a specific future date. The main difference between futures and forwards is the way in which they are negotiated. With forward contracts, terms like quantity, quality, and delivery date are discussed between the buyer and the seller.

A futures contract is basically a forward contract in which both parties consent to standard terms regarding the product and its quality, amount, and location; only the price is negotiable. A forward contract is a nonstandard arrangement agreed upon by two parties, which fixes the price for a commodity that will be delivered on a specific future date. A forward contract differs from a spot contract that agrees to buy or sell a commodity on the particular day the contract is being negotiated. In futures contracts, all terms are standardized. Forward contracts facilitate durable transactions between buyers and sellers but cannot deal with the financial risk that occurs with unanticipated price changes resulting from crop failures or transportation problems, thereby increasing risks for involved parties. This uncertainty led to the development of futures market.

Since futures are standardized contracts traded through an exchange, they can be used to diminish price risk by way of hedging methods. Hedging transactions limit “investment risk with the use of derivatives, such as options and futures contracts. Hedging transactions purchase opposite positions in the market in order to ensure a certain amount of gain or loss on a trade”. Commodity exchanges have slowly developed from physical markets where deals were struck in warehouses to futures markets that allow both hedging and speculation for gains in a rising market. The derivatives markets for futures at first assisted agricultural manufacturers and consumers to administer their price risks.

The futures markets developed from private negotiations to exchange commodities, mainly between the producer and the user. The agreements that stemmed from these negotiations became known as forward contracts. However, since standardized agreements ease the transaction process faster than forward contracts, the futures market was created.

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