You will learn about forward contracts and futures in this brief module. We will go into detail about what a forward contract and a futures contract are. By doing this, we will comprehend the distinction between the two and the rationale behind why investors use these derivatives.
What are a forward contract and a future, respectively? Both forwards and futures are contracts between two parties where one party seeks to buy and the other to sell, depending on an agreed transaction rate, a predetermined amount of a certain security for delivery at some future period in time.
The only difference between futures and forwards is that they are traded on different marketplaces, even though both types of contracts offer a guaranteed rate at which to interact in the future. By implication, this frequently also leads to various kinds of market participants trading in each.
But most crucially, there aren’t many distinctions between forwards and futures in terms of how they work because both are just as good at determining a transaction rate for the future.
A class of derivatives called futures, sometimes known as futures contracts, enables traders to fix the price of an underlying asset or commodity.
They are recognized by the month of its expiration. For instance, a gold futures contract for December expires in December. The phrase “futures” frequently refers to the entire market. However, there are a huge variety of futures contracts available for trading, such as: Futures contracts covering commodities like wheat, corn, crude oil, and natural gas Futures on stock indices like the FTSE/JSE Top 40 Index Futures on currencies Futures contracts for gold and silver It’s important to understand the distinction between options and futures. When an option contract expires, the holder has the option to buy or sell the underlying asset, whereas the holder of a futures contract must abide by the deal’s conditions.
A forward is traded on the Over The Counter (OTC) market. The market here is unadorned. In other words, participants negotiate deals directly with one another, and each contract is evaluated according to its own merits and particulars. This enables contracts to be made for any specified required amount, completed at a given rate, and delivered by a very specific delivery date. On the other hand, a future is a standardized contract that trades and clears through a major exchange; as a result, it is referred to as an ETI (exchange traded instrument). All contracts are uniform in terms of expiration date, quantity per contract, and upcoming expiration dates as a result of the contracts’ existence on the exchange. This is done to increase the exchange’s capacity to more effectively manage the exposures associated with each contract. One crucial lesson is that the existence of counterparty credit risk is one of the major worries when trading in the OTC market (also known as default risk). Exchange traded contracts make it possible to completely eliminate the risk of default.
Typical Futures Contract
Shares of business XYZ that you purchased cost R120 each, but they are now worth R150. You predict that a market slump will cause the price to decline in the upcoming months. You enter into a futures contract at a predetermined price of R160 per share that is actionable following the contract’s expiration in order to protect the profits you have gained from these shares.
When the contract expires, as you predicted, the price drops to R110 per share, and you sell your shares at the predetermined price of R160 per share to protect yourself from the share price decline.
Futures Trading Exchange (JSE)
Single Stock Futures (SSF) and Contracts for Difference are both available through the JSE (CFDs). Both of these futures contract types give an investor the chance to be exposed to the price fluctuations of an actual underlying share.
The investor now has full exposure to the direction of movement of the underlying share price in regard to the futures contract rate because they have locked in a rate at which the future transaction will occur by engaging into an SSF or a CFD (i.e., purchasing or selling the contract).
A residual risk occurs should the actual payout differ from what was anticipated because the price of an equity futures contract is calculated using an assumption of potential future dividends that have not yet been received throughout the life of the contract. The JSE also offers Dividend Futures to offset this risk.
A dividend futures contract tries to settle the net difference between the dividend that was used (implied) in determining the price of the underlying SSF contract and the dividend that actually occurred. It should be noted that trading Dividend Futures is optional and that it is traded in addition to SSF; in other words, only those who choose to insure against the dividend risk will do so.
Almost all of the Top 40 firms listed on the exchange are available as single stock futures and CFDs.
The JSE listed a few index futures that allow one to trade over a wider range of shares rather than just the shares of one particular firm, in addition to having these contracts available on actual company shares.