Forward and Futures Contracts

Background

Forward and futures contracts are important financial instruments used for hedging and speculative purposes. A forward contract is a customized agreement between two parties to buy or sell an asset at a specified price on a future date, whereas a futures contract is a standardized agreement traded on an exchange. Both types of contracts allow parties to lock in prices for future delivery, offering a hedge against price volatility.

Historical Context

Forward contracts have been in use for centuries, primarily in agriculture, to provide farmers and merchants a way to manage price risk associated with crop sales and purchases. Futures contracts, on the other hand, have a rich history dating back to the mid-19th century with the establishment of formal exchanges like the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME).

Definitions and Concepts

A forward contract is an agreement between two parties to buy or sell an asset at a future date for a price specified now. Unlike futures, forward contracts are not traded on an exchange and are customizable to fit the needs of the parties involved.

A futures contract is a standardized contract traded on an exchange that obligates the buyer to purchase, and the seller to sell, a particular commodity or financial instrument at a predetermined price at a specified time in the future. Futures contracts require the posting of margin and are marked to market daily.

Major Analytical Frameworks

Classical Economics

Classical economists generally focus on the role of risk and how derivatives like forwards and futures can mitigate uncertainty in markets, improving economic efficiency.

Neoclassical Economics

Neoclassical economists analyze these contracts in terms of supply and demand, price discovery, and their role in promoting more efficient allocation of resources through risk management.

Keynesian Economics

Keynesian economists might view futures and forwards as tools that companies use to stabilize investment and financial planning against volatile market conditions. These instruments can provide a predictable cash flow, aiding investment decisions.

Marxian Economics

From a Marxian perspective, forward and futures contracts could be scrutinized as speculative tools that can lead to market manipulation and price distortion, thus contributing to systemic risk.

Institutional Economics

Institutional economists study the influence of market regulations and institutions on the functioning of forward and futures markets. They examine the role of exchanges, settlement processes, and the legal frameworks governing these contracts.

Behavioral Economics

Behavioral economists look at how cognitive biases and irrational decision-making impact trading in forward and futures markets. They may examine how overconfidence or loss aversion affects hedging and speculative behaviors.

Post-Keynesian Economics

Post-Keynesian theorists view these contracts as means for firms to manage liquidity and cash flow outside the traditional banking system, offering stability in unpredictable economic environments.

Austrian Economics

Austrian economists might critique futures and forward markets for their potential to distort price signals, which could lead to misallocation of resources. They emphasize the importance of freedom from regulation in these markets.

Development Economics

Development economists explore how forward and futures contracts can aid emerging economies, especially in sectors like agriculture, by providing price certainty and encouraging investment.

Monetarism

Monetarists analyze how futures and forward contracts can be tools for managing inflation expectations and how they interact with monetary policy by affecting money supply through margin requirements and leverage.

Comparative Analysis

While both forwards and futures aim to set prices for future transactions, their key difference lies in their structure: forwards are privately negotiated and customizable, whereas futures are standardized and regulated by exchanges. Futures often require daily settlement through margin accounts which manage credit risk but lack the same level of customization available in forward contracts.

Case Studies

1. Agricultural Futures in the United States: Analysis of how corn and soybean futures help farmers and agribusinesses manage price risk.
2. Oil Futures in Commodity Markets: Assessment of the role of Brent and WTI crude oil futures in global energy markets and price stabilization.

Suggested Books for Further Studies

1. Options, Futures, and Other Derivatives by John C. Hull
2. Futures and Options Markets: An Introduction by Colin A. Carter
3. Principles of Financial Engineering by Robert Kosowski and Salih Neftci

Related Terms with Definitions

1. Hedging: A risk management strategy used to offset potential losses by taking an opposite position in a related asset.
2. Speculation: Engaging in risky financial transactions in an attempt to profit from short-term fluctuations in market value.
3. Margin: The collateral that a holder of a financial instrument has to deposit to cover some or all of the credit risk of their counterpart.
4. Mark-to-Market: An accounting method that values assets based on how much they could be