Evolution of the Forward Contract into a Futures Contract
The futures markets and the instruments traded there, as we know them today, have evolved from what began as private negotiations to buy and sell commodities between producers and users. The agreements that resulted from these negotiations are known as forward contracts. Fortunately, efficient-minded entrepreneurs discovered that standardized agreements can facilitate transactions in a much quicker manner than a privately negotiated forward contract, and thus, the futures contract was born. Next we take a look at the advent of the forward contract and how the concept eventually bred the futures contract.
The Forward Contract
The ingenuity of agricultural trade didn't end with the creation of organized and centralized grain trade in the 1800s. Although this certainly worked toward price stabilization by leveling shortages and surpluses throughout the growing and harvest cycles, other factors worked against price efficiency. As a means to mitigate price risks, farmers and merchants began dealing in forward contracts.
A forward contract is a private negotiation developed to establish the price of a commodity to be delivered at a specific date in the future. For example, a farmer that has planted corn and expects it to be harvested and ready to sell in October might locate a party interested in purchasing the product in October. At that time, both parties may choose to enter an agreement for the transaction to take place at a specific date, price, and location. Such an agreement locks in the price for both the buyer and the seller of the commodity and, therefore, eliminates the risk of price fluctuation that both sides of the contract face without the benefit of a forward contract.
Along with a centralized grain trade, the forward contract was another big step toward price stability, but there was a problem. Forward contracts reduce price risk only if both parties to the arrangement live up to their end of the agreement. In other words, there is no protection against default. As you can imagine, a farmer that locks in a price to sell his crop in the spring through a forward contract and discovers that he can sell the product for considerably more in the open market might choose to default on the forward contract.
It is easy to see the lack of motivation for parties to a forward contract to uphold their end of the bargain. Even the most honest man would be tempted to default if it means a better life for his family.
To resolve the issue of merchants and farmers defaulting on forward contracts, the exchanges began requiring that each party of the transaction deposit a good-faith deposit, or margin, with an unrelated third party. In the case of failure to comply with the contract, the party suffering the loss would receive the funds deposited in good faith to cover the inconvenience and at least part of the financial loss.
The Futures Contract
- In its simplest form, a futures contract is a standardized forward contract.
Exchange-traded forward contracts were extremely helpful in reducing the price risk that farmers and merchants would normally be exposed to. Additionally, with the advent of exchange-traded forward contracts along with good-faith deposits, much of the default risk was eliminated. However, because forward contracts were negotiations between two individuals, it was a challenge to bring buyers and sellers together that shared the same needs in terms of quantity, timing, and so on. Also, forward contracts were subject to difficulties arising from uncontrollable circumstances such as drought. For example, a farmer obligated to deliver a certain amount of corn via a forward contract might not comply due to poor growing conditions, thus leaving the counter-party to the transaction in a dire predicament.
The exchanges' answer to problems arising from forward contracts was the standardized futures contract. In its simplest form, a futures contract is a forward contract that is standardized in terms of size, deliverable grade of the commodity, delivery date, and delivery location. The fact that each contract is identical to the next made the trading of futures much more convenient than attempting to negotiate a forward contract with an individual. It is the concept of standardization that has allowed the futures markets to flourish into what they have become today.
According to the CME, the formal definition of a futures contract is as follows:
- A legally binding, standardized agreement to buy or sell a standardized commodity, specifying quantity and quality at a set price on a future date.
In other words, the seller of a futures contract agrees to deliver the stated commodity on the stated delivery date. The buyer of a futures contract agrees to take delivery of the stated commodity at the stated delivery date. The only variable of a futures transaction is the price at which it is done, and this is determined by buyers and sellers in the marketplace.
Although the futures contracts bought or sold represent an obligation to take or make delivery, according to the CME approximately 97% of futures contracts never result in physical delivery of the underlying commodity. Instead traders simply offset their holding prior to the expiration date. We discuss this in more detail later in the chapter.
In the evolution into the futures contract and away from the forward contract, exchanges also eliminated default risk associated with buying or selling futures contract by guaranteeing the other side of the transaction. Thus, unlike a forward contract, or early versions of the futures contract, in which each parties are left to depend on the other to live up to their end of the contract; a futures contract is backed by the exchange. This exchange guarantee covers the entire value of the position as opposed to being limited to the margin posted by participants.
Thanks to the standardization of each contract, the subsequent ease of buying or selling contracts, and a lack of default risk, futures trading has attracted price speculation. Participation is no longer limited to those who own, or would like to own, the underlying commodity. Instead unrelated third parties can easily involve themselves in the markets in hopes of accurately predicting, and therefore profiting from, price fluctuations.