What Are Futures and Forwards? A Quick Overview
Imagine you’re a farmer growing wheat, and you’re worried prices might crash by harvest time. Or maybe you’re a jeweler who needs gold but fears prices will skyrocket. This is where futures trading and the forwards market come in. Both are types of financial derivatives, meaning their value comes from an underlying asset—like wheat, gold, or even a stock.
A forwards contract is a private deal between two parties to buy or sell an asset at a set price on a future date. Think of it as the older cousin of futures contracts, which are standardized and traded on exchanges like the NSE or BSE in India. Forwards are like custom-made agreements, while futures are ready-to-wear, regulated, and accessible to more traders.
In this post, we’ll focus on the forwards market to build a foundation for understanding futures trading, explore real-world examples, and weigh the pros and cons.
A Glimpse into History: Forwards in Ancient India
Believe it or not, derivatives aren’t new. Back in 320 BC, the Indian economist Kautilya mentioned a system in his book Arthashastra. He described paying farmers in advance for crops to be harvested later, fixing the price upfront. That’s basically a forwards contract! This method helped farmers secure income and buyers lock in prices, protecting both from price swings. Fast forward to today, and forwards are still used, especially by businesses like jewelers or importers.
How Does a Forwards Contract Work? A Real-World Example
Picture this: It’s December 9, 2024, and you’re a jeweler (let’s call you ABC Jewelers). You need 15 kilograms of gold in three months for your spring collection. Gold prices are Rs. 2,450 per gram today, but you’re worried they’ll climb by March 2025. You strike a deal with XYZ Gold Dealers, a gold importer, to buy 15 kg of gold (999 purity) on March 9, 2025, at today’s price—Rs. 2,450 per gram, or Rs. 3.675 crores total.
This is a forwards contract, a private, over-the-counter (OTC) agreement with:
- A fixed price (Rs. 2,450/gram).
- A set delivery date (March 9, 2025).
- No middleman—just you and the dealer.
Why do this? ABC Jewelers locks in the price to avoid a cost spike, while XYZ Gold Dealers bets prices will drop, letting them sell at a premium later.
Why Enter a Forwards Contract? The Motivation
Both parties in a forwards contract have their reasons:
- The Buyer (ABC Jewelers): You think gold prices will rise. By locking in today’s price, you save money if prices soar. It’s like booking a flight early to avoid a fare hike.
- The Seller (XYZ Gold Dealers): They believe prices will fall. Selling at today’s higher price means a profit if the market drops.
This opposing view is what makes the deal tick.
Three Possible Outcomes of a Forwards Contract
Once the contract’s date arrives, the price of the underlying asset (gold, in our case) could move in three ways:
Scenario 1: Gold Prices Rise
Suppose gold hits Rs. 2,700 per gram on March 9, 2025. The 15 kg is now worth Rs. 4.05 crores, but ABC Jewelers pays only Rs. 3.675 crores as agreed.
- ABC Jewelers: Saves Rs. 38 lakhs—a win!
- XYZ Gold Dealers: Loses Rs. 38 lakhs, as they must buy gold at Rs. 2,700/gram to sell at Rs. 2,450/gram.
Scenario 2: Gold Prices Fall
Now, gold drops to Rs. 2,050 per gram, valuing the 15 kg at Rs. 3.075 crores.
- ABC Jewelers: Loses Rs. 59.5 lakhs, stuck buying at Rs. 2,450/gram when the market’s cheaper.
- XYZ Gold Dealers: Gains Rs. 59.5 lakhs, selling high while buying low.
Scenario 3: Prices Stay the Same
If gold stays at Rs. 2,450/gram, neither party gains or loses. The deal’s value remains Rs. 3.675 crores.
Settling a Forwards Contract: Cash or Physical?
When the contract matures, the parties settle in one of two ways:
- Physical Settlement: The buyer pays the full amount, and the seller delivers the asset. XYZ buys 15 kg of gold at the market price (say, Rs. 4.05 crores) and delivers it to ABC for Rs. 3.675 crores.
- Cash Settlement: No goods change hands. The parties exchange the price difference. If gold is Rs. 2,700/gram, XYZ pays ABC Rs. 38 lakhs.
The Risks of Forwards Contracts: What to Watch Out For
Forwards sound great, but they’re not without pitfalls:
- Liquidity Risk: Finding a counterparty with the opposite view isn’t easy. You might need an investment bank to match you, and that costs fees.
- Default Risk: What if XYZ Gold Dealers can’t deliver the gold or ABC Jewelers can’t pay? There’s no regulator to enforce the deal.
- Regulatory Risk: Forwards are OTC, meaning no SEBI or RBI oversight. This lack of regulation can lead to disputes or defaults.
- Rigidity: Once signed, you’re locked in. If your view on gold changes mid-contract, you can’t back out easily.
Why Forwards Matter for Futures Trading
The forwards market is the foundation of futures trading. Futures evolved to fix forwards’ flaws:
- Standardization: Futures have fixed contract sizes and dates, unlike custom forwards.
- Exchange-Traded: Futures trade on platforms like NSE, with clearinghouses ensuring no defaults.
- Liquidity: Futures markets have many buyers and sellers, making trades easier.
Who Uses Forwards Today?
While futures dominate, forwards are still used by:
- Businesses: Importers, exporters, or manufacturers use forwards to hedge price risks.
- Banks: Financial institutions trade currency forwards to manage exchange rate risks.
- Farmers: In India, some agricultural deals still use forwards, though futures are growing via exchanges like NCDEX.
Pros and Cons of Forwards Contracts
Pros
- Customization: Tailor the contract to your exact needs (amount, date, price).
- Hedging: Protect against price swings, crucial for businesses.
- Simplicity: Straightforward agreement, no exchange fees.
Cons
- High Risk: Default and liquidity risks can lead to losses.
- No Flexibility: You’re locked in, even if market conditions change.
- No Regulation: Disputes can be messy without a regulator.
How Forwards Set the Stage for Futures Trading
Futures contracts keep the core idea—agreeing on a future price—but add safeguards like:
- Clearinghouses: Guarantee trades, eliminating default risk.
- Daily Settlements: Mark-to-market adjustments prevent big losses.
- Transparency: Prices are public, and trades are regulated by SEBI.
Getting Started with Futures Trading
Ready to explore futures trading? Here’s how to begin:
- Learn the Basics: Understand derivatives through resources like Zerodha Varsity.
- Open a Trading Account: Choose a broker like Zerodha or Upstox and activate F&O trading.
- Start Small: Trade one lot of a low-cost future, like Bank Nifty, to learn the ropes.
- Use Risk Management: Set stop-losses to limit losses, as futures can be volatile.
- Stay Informed: Follow market news on platforms like Moneycontrol.
Conclusion: Why Futures and Forwards Matter
The forwards market is like the roots of a tree, supporting the branches of futures trading. Forwards contracts let businesses and traders hedge risks and plan ahead, but their risks paved the way for the safer, more accessible futures market.