Differentiating forward and future contracts

Jan 11 2013, 08:59 IST
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SummaryForward contracts and futures contracts are classified as ‘commitment contracts’, which impose a performance obligation on both the long as well as the short.

Forward contracts and futures contracts are classified as ‘commitment contracts’, which impose a performance obligation on both the long as well as the short. However, while forward contracts are customised or over-the-counter (OTC) products, futures contracts are standardised or exchange-traded products.

In the case of the former, all aspects such as the lot size, or the number of units of the underlying asset to be delivered per contract; the grade of the underlying asset, for commodities which are characterised by multiple grades; the location for delivery; and the delivery date are decided by bilateral discussions between the two parties to the contract.

Consequently, the contract may be structured in any way that the two parties deem fit. In futures contracts, however, there is an exchange, which will specify the lot size; one or more deliverable grades and delivery locations; as well as the delivery period. As this suggests, while the exchange in practice does give an element of choice to the two counterparties, they cannot design a contract beyond the boundaries specified by it.

Let us take each of the features of a futures contract. The lot size is set by the exchange, as is the delivery period. In some cases, there is a single delivery date. This is the case for cash settled contracts where there is no question of delivery. For instance, all stock and stock index futures on the NSE expire on the last Thursday of the month.

However in most commodity futures contracts, the exchange will specify a ‘delivery window’. For instance, the exchange may state that delivery for a contract may take place at any time between the 15th calendar day and till the last working day of the delivery month.

In such cases, the exchange needs to specify as to who will initiate the delivery process, for if this is not stated, then there is, obviously, the potential for conflict. In practice, the right to choose the delivery date is usually given to the short. The delivery process itself is initiated by the short. That is, if a short were to put up his hand and state his desire to deliver, the exchange will identify one among the many eligible longs to accept delivery.

Thus, a long cannot raise his hand and demand delivery. What this means in practice is that those longs who have taken a position without any intention to take delivery, will exit the market prior to

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