Forward
and futures markets are both types of derivative contracts that allow traders
to buy or sell an asset at a future date and a predetermined price. Here are
brief descriptions of each market and examples of how they work:
Forward Market:
The forward market is a non-standardized contract between two parties to buy what
is Liquidity Management or sell an underlying asset at a specified price and
future date. The contract is customized and settled at the maturity date. The
contract is not exchange-traded and is negotiated between the two parties
involved, which means that the terms and conditions can be tailored to their specific
needs.
Example:
Suppose that an importer of goods in the United States expects to receive a
shipment of goods from a supplier in Japan in six months. To protect against
currency risk, the importer can enter into a forward contract with a bank to
purchase Japanese yen at a fixed exchange rate in six months. This way, the
importer knows exactly how much it will cost in dollars to buy the yen when the
goods arrive, regardless of how exchange rates move between now and then.
Futures Market:
Futures markets are exchange-traded contracts that require the buyer and seller
to exchange the underlying asset at a future date and at a predetermined price.
Futures contracts are standardized and traded on an exchange, with the terms
and conditions of the contract predetermined by the exchange. Futures contracts
are settled daily based on the current market price of the underlying asset.
Example:
Suppose that a farmer is expecting to harvest a crop of corn in six months. The
farmer can enter into a futures contract with a buyer to sell the corn at a
fixed price in six months. This way, the farmer can lock in a price for the
corn before it is harvested, regardless of how market prices move in the
meantime.
In
summary, both forward and futures markets allow traders to buy or sell an
underlying asset at a predetermined price and date. The key difference is that
the forward market is a customized contract negotiated between two parties,
while the futures market is a standardized contract traded on an exchange.