Series 3 Study Textbook

How to Understand Futures and Forwards and Pass Your Series 3 Exam
and forwards and pass your series 3 exam

One of the keys to passing the series 3 exam is to make sure that you understand the difference between futures and forward contracts. . This article, which was produced from material contained in our series 3 textbook, will help you master the material so that you pass the series 3 exam.


What are Futures and Forwards?

While commodity futures contracts are seen by many market participants as strictly financial instruments, commodity futures contracts are truly an evolution of market efficiency. Commodity futures contracts have allowed the producer and user of commodities to operate their business more efficiently and to manage risk associated with changing prices.

The Spot Market

Before the development of financial instruments and contracts, commodities were bought and sold in cash transactions. The transactions between the producer or seller of the commodity and the user or buyer of the commodity took place in the cash or spot market. In the spot market the producer of the commodity would bring his crop to the marketplace and sell the wheat or corn to any buyer with cash in hand. The spot market gets its name from the fact that the commodity is delivered and paid for “on the spot.” The producer of the commodity who has the commodity on hand is said to be long the cash commodity. If the grower of corn has 100,000,00 bushels of corn stored in their silo, the farmer (producer) is said to be long 100,000 bushels of cash corn. The user of the commodity who does not have the commodity on hand but who needs to acquire the cash commodity in order to produce their product or to conduct their business is said to be short the cash commodity. A grower of cattle who needs the corn to feed his cattle would be considered to be short cash corn because the grower does not have the corn on hand and needs the corn to conduct his business and to feed his cattle. Alternatively, someone who has a contractual obligation to deliver the underlying cash commod- ity but who does not own the cash commodity would also be considered to be short the cash commodity. If a U.S. exporter has contracted to deliver 50,000 bushels of corn to a cattle grower in Mexico in 120 days but has not acquired the 50,000 bushels of corn, the exporter would be considered to be short cash corn.

Forward Contracts

The first advancement in commodity trading was the development of cash forward contracts or forwards. Forward contracts are privately negotiated contracts for the purchase and sale of a commodity or financial instrument. The first forward contracts were developed for agricultural commodities like wheat and corn. The establishment of forward contracts allowed the buyer and seller of commodities to lock in prices for a delivery date in the future. The forward contract gave both parties the ability to manage their businesses more efficiently. Farmers could now grow crops knowing that they had locked in a sale price for the crop. The forward contract also allowed the farmer to sell their crop without having to haul it to market, hoping there were buyers waiting with cash in hand. The buyer or users of the commodities through the use of a forward contract now knew that they had locked in the supply of the commodity to meet their demand at a set price. Both parties to the forward contract have an obligation to per- form under the contract. The buyer is obligated to accept delivery of and pay for the commodity at the agreed?upon time and location. The seller is obligated to deliver the stated amount and quality of the commodity at the agreed?upon time and location. Because the terms and conditions for each forward contract are negotiated on an individual basis, it is extremely difficult to find another party to take over the obligation under the con- tract should circumstances change between the contract date and the delivery date. There is no secondary market for forward contracts. Another drawback to the forward contract is counterparty or performance risk. The individual counterparty risk is borne by both parties to the forward contract. For the seller or producer of the commodity it is the risk that the buyer will not be able to make payment or take delivery. For the buyer of the commodity the counterparty risk is that the farmer may not be able to produce or deliver the commodity. If one party defaults on their obligation to perform under a forward contract there is no entity to step in to ensure that the other party is made whole. In modern financial markets, forwards are often used in the currency markets by corporations and banks doing business internationally. If a corporation knows that it needs to make a payment for a purchase in foreign currency three months from now, the corporation can arrange to purchase the currency from a bank the day before the payment is due.

Futures

As the use of forward contracts evolved, the need to offset obligations through a secondary market and to eliminate counterparty risk led to the develop- ment of commodity futures contracts. Futures, like forwards, are a two?party contract. The specific terms and conditions of the contracts are standardized and set by the exchanges on which the futures contracts trade. The contract amount, delivery date, and type of settlement vary between the different types of futures contracts. Many futures contracts are an agreement for the delivery of a specific amount of a commodity at a specific place and time such as 5,000 bushels of wheat during the delivery period of the contract month. Futures began to trade for commodities such as wheat and gold and over the years have expanded to include financial futures such as futures on Treasury securities and most recently single stock futures. The standardized contract terms allows for a very liquid secondary market. The counterparty risk has been eliminated through performance guarantees. So even if one party to a contract defaults and does not meet their obligation, the other party will be made whole. Investors and hedgers can establish both long and short positions in commodity futures contracts. A person who has purchased the futures contract is long the contract, and until the buyer executes an offsetting sale the contract remains open. Alternatively a person who has sold the futures contract to open the position is considered to be short the futures contract, and until the seller closes out the contract with an offsetting purchase the contract remains open.

The Role of the Futures Exchange

The futures exchange at the most basic level provides a centralized location where buyers and sellers come together to transact business in futures. The exchange provides a centralized location where producers and users of com- modities can lock in prices, manage their business, and hedge their risks. A farmer can lock in a sales price for his corn production by selling corn futures. A baking company may lock in a price for wheat by purchasing wheat futures. By engaging in futures transactions, the producer of corn and the buyer of wheat have both hedged their risk and can now operate their businesses more efficiently and without immediate concern over large price swings. The use of futures contracts has resulted in a reduction in busi- ness risk and commodity costs. These cost savings are passed along to the economy as buyers of the finished product enjoy the lower prices for finished goods like a loaf of bread. Additionally, because futures reduce the business risk to the producers and users of commodities, these companies are now able to obtain credit at lower rates. A lender reviewing the loan application of a farmer who grows corn will be more confident in making the loan if the lender knows that the farmer has locked in a sale price for his product. Finally, the exchange provides a place for risk capital to speculate on the direction of various commodities. These speculators provide a significant level of liquidity to the marketplace and make it easier for producers and users to hedge their business risk in the underlying cash commodity. These speculators are willing to assume the risk that producers and users want to eliminate.