Forward Contract

The speaker provides a detailed overview of the price movements of futures contracts.  These concepts are known as contango and backwardation; he further goes on to cover Normal Contango and Normal Backwardation.  He also discusses how different commodities have different seasonality which can result in a backwardation.

Contango refers to a forward price of a commodity being higher than the spot price while backwardation refers to the forward price being lower than the spot price.  This is common in some commodities during different times of the year; however, it is uncommon in some commodities such as gold and silver.

Video explaining why futures prices are different from forward prices even if the underlying assets and terms of both are the same.

The difference between the two is that the forward contract is traded on an OTC market where the primary risk is counterparty risk of default.  Conversely, in a futures contract, the primary risk is basis risk and not counterparty risk.  Futures contracts trade on an exchange which is basically the other side of the trade, rather than another counterparty. 

The prices in these contracts differ due to daily settlement.  For those who are long a futures contract, there will be daily settlement of gains, or losses, on a nightly basis.  That means that if the spot price of the underlying goes up, the account will have excess margin, thereby allowing the investor to reinvest at a higher rate.  Forward contracts do not have this call and would render them less valuable.  Conversely, if the spot price falls, there will be a margin call which will require the futures trader to inject additional cash into the account using borrowed money, thereby rendering the forward contract more valuable.

What is a Forward Contract?

Similar to a futures contract, a forward contract is an agreement for the future delivery of a specified amount of goods at a predetermined price and date.

How do Futures & Forward Contracts Differ?

Forward contracts are usually not standardized as futures are; they are traded over the counter directly between buyer and seller. Futures contracts, on the other hand, are standardized and traded on organized exchanges.

Another key difference between a futures and forward contract is in the delivery of the underlying asset. Futures contracts are typically not meant for actual delivery of an asset. In reality, about 2% of futures contracts actually require delivery. Conversely, forward contracts are meant for delivery. This delivery is usually in the form of cash settlement as opposed to physical delivery.

Forward contracts are settled at the expiration of the contract; alternatively, futures are marked to market. This means that the daily changes in the price of the futures contracts are settled daily until the contract expires.

One other key distinction to make between futures and forward contracts is in the credit risk that is inherent in forwards. Since either party of a forward contract can default on their obligation to take delivery or to deliver an asset, forwards are more risky than futures. As noted above, futures are traded on exchanges, backed by clearinghouses which will guarantee the futures contract.