Differences Between Futures and Forward Contracts

The difference between a futures contract and a forward contract reveals itself in the way the two contracts are used, how they are regulated, the extent to which each type of contract is utilized, and their influence on financial markets. In fact, there are a number of significant differences between a futures contract and forward contract even though they are related via a historical connection. • Futures contracts evolved out of Forward contracts Futures contracts are a financial instrument that evolved out of forward contracts. Historically, farmers, banking institutions and buyers used to negotiate purchase and delivery of a commodity where the banking institution offered a letter of credit to the supplier based on the purchaser's credibility. In turn the farmer would deliver goods on a specified date and was paid by the banker. The banker then settled with the buyer. Over time commodities exchange process became more sophisticated and the forward contracts themselves were bought and sold without actual delivery of the commodity. Eventually around the middle of the 19th century exchanges emerged in which these contracts were traded in the form of Futures contracts which led to more differences between the two types of contracts. These differences are outlined as follows: • Futures contracts are traded more frequently Futures contracts are more common within financial markets whereas forward contracts are not as vulnerable to price differences caused by frequent exchanges with price differences that reflect changes in market conditions. Additional differences between futures and forward contracts Several specific differences between futures and forward contracts exist. These differences can help distinguish between futures and forward contracts. The following factors illustrate the difference between a futures contract and a forward contract and demonstrate how different these two contracts actually are. • Regulation Forward contracts are not regulated in the same as Futures contracts are. Futures contracts are subject to more oversight from organizations such as the Commodity Futures Trading Commission (CFTC). A history of futures contract regulation can also be found at the CFTC website. • Contract Terms Negotiating a forward contract can be done in a restaurant, at a golf game or at a business meeting. Futures contracts are conducted exclusively through a trading exchange such as the Chicago Board of Exchange. • Derivative Commodity While forwards and futures can theoretically trade in anything, in practice Futures are limited to what the exchange incorporates into its trading mechanism. For example, The Chicago Board of Exchange facilitates futures contracts in agricultural, bond futures and metals futures. Forward contracts have more flexibility in what is traded due to the fact they do not have to be traded through an exchange. • Fees and/or Commission Futures contracts usually involve some kind of fee and/or commission whereas forward contracts between individuals do not have to incur finance charges. • Trading Process Futures are bought and sold in high volumes that would be impractical for forward contracts with delivery. These high volumes are rapidly facilitated through real time exchanges whereas forward contracts can be bought and sold at a coffee shop or business meeting after hours of negotiation. • Insurance The exchange of futures contracts is not always insured whereas the commodities in a forward contract are more likely to be insured. • Contractors and Contractees Since forward contracts have more flexibility, they are more likely to be entered into by a wider variety of contractors and contractees. Futures contracts on the other hand are traded in a more exclusive manner. For example, food distributors and retailers have forward contract when negotiating the future delivery of watermelons for a specified wholesale price, whereas commodities brokers are more likely to buy and sell derivative contracts such as those involving the exchange of oil. Source: http://www.cftc.gov (Commodities and Futures Trading Commission)

Understanding Futures' Tick Size and Tick Volume

Understanding a futures contract's tick size and tick value is essential in the trading of futures financial instruments. These financial instruments are a type of contract that lock in to prices in the present and are either sold or bought at that price in the future. Commodities and currency are often traded in the futures markets such as the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME)

Tick size is a metric used in futures exchanges and trading that accounts for the smallest unit measure by which the price of a financial instrument can move up or down. Not all financial instruments have the same tick sizes and even those that are similar i.e. Treasury securities, tick sizes vary.

To illustrate tick size further, according to the Chicago Mercantile Exchange (CME), the tick size for a 30 year U.S. Treasury Bond Future is 1/2 of 1/32 of a point. This means each basis point is comprised of individual ticks of .015625. If 100 basis points is one percent, then the tick size is 1/64th of a basis point which is between 1/100th and 2/100ths of a percent, or more accurately .00015625

Tick value represents cost or profit in proportion to the tick size. In other words, a move in tick size will have differing advantages and disadvantages depending on how much money one has invested. Since tick sizes can be so small, very large amounts of money or quantity are needed to influence price movement significantly enough to be worth while.

For example, suppose Mrs. Smith wants to take part in a foreign exchange option. She chooses a currency pair and an exchange rate with which to sell at at a future date. The currency pair is the U.S. Dollar against the Japanese Yen and the exchange rate is 81.3400, meaning one dollar can be purchased with .8134 Yen indicating the Yen is a stronger currency. Now suppose the value of the dollar rises against the Yen i.e. one dollar buys more Yen buy 1 uptick, which is 1/100th of a cent, how much does Mrs. Smith make or lose?

To answer this question we need to understand the futures tick size and value in addition to the amount invested and the strike price. If Mrs. Smith buys $100,000 Dollars with the right to sell at an exchange rate with the Yen at 81.34 within 60 days and the value of the dollar against the Yen increases by ten upticks to ¥81.44, then the value of the Yen has risen by 10,000 which after conversion to dollars at the new rate would be $8,144. In light of this not exercising the option and forgoing the option premium is a wiser choice.

Since futures markets are often highly leveraged to take advantage of relatively small tick movements the risk can be quite high. This is why understanding exactly what a futures tick size and value are is crucial because one small miscalculation could end up costing thousands of dollars if one is overly leveraged and/or a large tick movement occurs.

Sources:

1. http://bit.ly/cPXRPG (Chicago Mercantile Exchange)
2. http://yhoo.it/37rUpV (Yahoo Currency Exchange Convertor)
3. http://bit.ly/bwNEzH (Commodity Futures Trading Commission)