Futures & forwards

A commodity is a raw material or agricultural product that has economic value of some sort. Here’s a list of common commodities:

• Soybeans
• Sugar
• Corn
• Live cattle
• Natural gas
• Oil
• Gold
• Lumber

If you’re curious, here’s a list of traded commodities.

Market prices of commodities fluctuate regularly, similar to the stock market. This environment presents both opportunities and challenges. Investors can speculate on the price of commodities and have the opportunity to make a return if their bet pays off. On the other hand, those that work directly with commodities (e.g. farmers, distributors, miners) may be concerned with rising or falling prices, and therefore work to hedge their risk.

A person can use forwards and/or futures for speculation or hedging purposes. Test questions tend to focus on the characteristics of these derivatives, while comparing and contrasting their similarities and differences.

Futures contracts

Futures contracts establish a “locked-in” transaction price to deliver a commodity in the future. These derivatives share a number of similarities with options, which include:

• Standardized contracts
• Locked in a future transaction price
• Sellers have obligations
• Can be used to speculate on market prices
• Trade on exchanges

Similar to how stock options typically involve 100 shares per contract, futures contracts cover transactions of a specified number of units depending on the commodity in the future. For example, a milk futures contracts cover the delivery of 200,000 pounds of milk. Every milk futures contract covers the same amount of milk to be delivered. This demonstrates how futures contracts are standardized.

Buyers of futures contracts are obligated to purchase the commodity at a fixed price in the future, while sellers are obligated to sell the commodity at that same fixed price in the future. Unlike option contracts, the buyer does not have a right. Futures contracts basically lock both sides to a transaction at a fixed price that will occur in the future. For example:

Futures contract for 20 tons of live cattle at $3.

This futures contract would result in:

• Futures buyer: obligation to buy 20 tons @ $3/pound
• Futures seller: obligation to sell 20 tons @ $3/pound

The futures buyer is bullish, betting the price of live cattle will go up. If it does, they have a contract that results in the purchase of the commodity at a lower price, resulting in a gain. If the price of livestock falls, the contract will force a purchase at a higher price, resulting in a loss. Although the buyer could take part in the exercise of the contract and actually purchase 20 tons of live cattle, the vast majority of futures contracts are closed out prior to exercise of the contract. Meaning, the buyer sells their contract prior to the transaction actually occurring. By doing so, the buyer is relieved of their obligation to buy. It’s estimated somewhere above 95% of futures contracts do not result in a commodity transaction.

The futures seller is bearish, betting the price of live cattle will go down. If it does, they have a contract that results in the sale of the commodity at a higher price, resulting in a gain. If the price of livestock rises, the contract will force a sale at a lower price, resulting in a loss. The seller could take part in the exercise of the contract and actually sell 20 tons of live cattle, but we already know the vast majority of futures contracts are closed out prior to exercise of the contract. Meaning, the seller buys back their contract prior to the transaction actually occurring. By doing so, the seller is relieved of their obligation to sell.

Due to the nature of futures traders typically closing out their contracts prior to exercise, it can be assumed these investments are used primarily for speculation. If the good actually needed to be bought or sold, a large percentage of contracts would not be closed out. It’s also possible to use a futures contract to hedge. For example, an investor holding a significant amount of oil company stock sells oil futures. If the oil company stock declines due to falling oil prices, the oil future results in a gain (selling futures is bearish on the commodity), offsetting those losses.

Futures trade on exchanges and typically don’t face much liquidity risk. This is partially attributed to the standardization of contracts. When every contract traded has similar characteristics, it’s easy to trade those contracts in a market. Otherwise, customized contracts covering varying numbers of units would require a great deal of research and inspection prior to buying or selling.

In summary, here are the important futures test points to be aware of:

• Standardized contracts to perform a future transaction at a fixed price
• Buyer has obligation to buy (bullish)
• Seller has obligation to sell (bearish)
• Trade on futures exchanges (high liquidity)
• Utilized primarily by speculators

Forward contracts

Forward contracts also establish a “locked-in” future transaction price on a commodity. They are very similar to futures contracts in many ways. Let’s establish those similarities:

• Contracts to perform a future transaction at a fixed price
• Buyer has obligation to buy (bullish)
• Seller has obligation to sell (bearish)

The overall purpose of the contract (to deliver a commodity for a set price) and the obligations of the buyer and seller are exactly the same. With that being said, let’s cover the differences:

• Custom (non-standardized) contracts
• Do not have a trading venue
• Utilized primarily by those working directly with the commodity

Unlike futures, forward contracts are customized based on the needs of both the buyer and the seller. For example, let’s assume a corn farmer projects their harvest to be 2.5 metric tons and they intend to deliver the corn to a cereal distributor. Also, assume both the farmer and the distributor are concerned about price fluctuations. If there’s an oversupply of corn due to favorable weather conditions, it’s possible the price of corn will fall, which would negatively impact the farmer. If there’s a shortage of corn, it’s possible the price of corn will rise, which would negatively impact the distributor.

To hedge themselves against the risk of price fluctuations prior to harvest, the two parties could enter into a forward contract. It would be non-standardized to fit the situation, allowing a custom amount of corn to be delivered at a custom date in the future. It’s nearly impossible to create a trading market for non-standardized contracts, so there is no secondary market for forwards. Unlike futures, most forward contracts result in the delivery of the commodity. Therefore, forwards are subject to high levels of liquidity risk.

In summary, here are the important forwards test points to be aware of:

• Customized contracts to perform a future transaction at a fixed price
• Buyer has obligation to buy (bullish)
• Seller has obligation to sell (bearish)
• No trading market (low liquidity)
• Utilized primarily by those working directly with the commodity