Forwards and futures markets are exchange-traded contracts and are highly standardized. However, they are not the same. Here are some basic differences between the forwards and futures markets. You can find out which one is more appropriate for your trading needs by reading this article. The prime difference between futures and forwards is their funding mechanisms.
Commodity Instruments
A significant advantage of using the forwards and futures markets for commodity-based financial instruments is their ability to hedge risk. By establishing margin accounts, investors can trade on both sides of the market. However, the high degree of leverage often results in high risk and can lead to margin calls and unfavorable price movements. Many businesses use these instruments to lock in prices for their raw materials. A good example is the cocoa futures market in New York, which has irregular expiration dates due to seasonality.
The difference between the forwards and futures market for commodity-based financial instruments is most obvious in the way they operate. With a forward contract, both parties must make an initial margin payment. Future contracts, on the other hand, may not necessarily mature by the delivery of the commodity. Nevertheless, the value of the operation is marked to market rates on a daily basis. While futures contracts are generally illiquid, the forward market for commodity-based financial instruments has several benefits.
Financial Aspects
The difference between the financial futures and forward markets lies in their funding mechanisms. The former represent exchange-traded contracts that have standardized conditions, while the latter are private, negotiated contracts that have no standardized conditions. Forwards have an underlying asset, such as a commodity, and futures have an underlying asset that has a defined expiry date. They can also be highly personalized and may not allow early exit.
The price of a futures contract is determined by compounding the present value S(t) at t to maturity T at a risk-free rate r. The price is determined within arbitrage boundaries around the theoretical price. Financial futures and forwards are used to hedge against risks associated with a particular commodity. While the prices are different, they often trade at close to their theoretical value. Because of this difference, investors can benefit from the price volatility associated with these contracts.
The Level of Commodity
The fundamental difference between the forwards and futures markets is that the forwards have no standard exchange rate. Instead, the parties to the contract agree to “true up” the contracts every quarter. This creates a large difference between the delivery and settlement prices, which leads to unrealized gains and losses. Further, these two forms of trading are often not available to retail investors.
The futures market is a more reliable source of information about commodity prices than the cash forward contract market because the difference is directly related to the level of the commodity. In addition, it is possible for futures prices to fluctuate, even when the price of the commodity has not changed at all. However, these price changes should be interpreted with caution since they may not accurately reflect the changes in actual spot prices.
Cash-Settled Futures & Forwards
The LME’s cash-settled futures and forwards market use DCVM to settle trades. Profits and losses are realized daily between LME Clear and its members. For hedging purposes, physical futures are more flexible because they offer a personalized average price. Cash-settled futures and forward contracts are based on the current market price. As such, the key to successful trading in any given contract is choosing the most appropriate PRA.
In a typical futures contract, the buyer agrees to purchase an asset at a specified price at a future date. There exist some differences between these contracts, though. Unlike the forwards market, the futures market is highly liquid. It is also popular with speculators, as delivery is not possible. For these reasons, cash-settled futures and forwards markets tend to be liquid.