Friday, April 22, 2011

What is the difference between forward and futures contracts?

This is an important question, so I thought I'd elaborate on it.  In earlier blogs, I have speculated that JPMorgan has (technically) and will (outright) default on delivery of physical silver.  That's a pretty bold speculation.

What's even bolder is declaring the COMEX, the exchange where futures contracts are transacted, will also default on silver delivery.  A default by the COMEX would announce to the world that something is very wrong if the exchange itself cannot reconcile the default of one of its major members.  The credibility of the largest commodities exchange--and the global financial system, would be under fire should the COMEX default.  It would be a force majeure-type of event, and one the COMEX would have to declare after such an event.

According to Investopedia:
Fundamentally, forward and futures contracts have the same function: both types of contracts allow people to buy or sell a specific type of asset at a specific time at a given price.

However, it is in the specific details that these contracts differ. First of all, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.

Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date

Lastly, because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place.
One can see in the bold-faced segment that the major difference between a forward and futures contract is that the latter is conducted in a clearinghouse or exchange, which in this case is the COMEX.  In a forward contract, either party may default, even if it is rare.

With futures markets, a default between two parties is even rarer because members need to pass minimum capitalization criteria, and because the COMEX has always stepped in and guaranteed the transactions, should one of the parties default.  But should the COMEX in turn default in delivery of said inventory (i.e. the buyer refuses cash settlement), the credibility of the COMEX itself would be in jeopardy, which would cause panic in commodities markets worldwide.

So a declaration that the COMEX could default should not be taken lightly.  It would be a major event.

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