Forward Contract

Forward contracts are agreements where one party agrees to buy a commodity at a specific price on a
specific future date and the other party agrees to make the sale. Goods are actually delivered under
forward contracts. Unless both parties are financially strong, there is a danger that one party will default
on the contract, especially if the price of the commodity changes markedly after the agreement is
reached.

Future Contract
A futures contract is similar to a forward contract but with three key differ- ences:
 Futures contracts are “marked to market” on a daily basis, meaning that gains and losses are
noted and money must be put up to cover losses. This greatly reduces the risk of default that
exists with forward contracts.
 With futures, physical delivery of the underlying asset is never taken—the two parties simply
settle with cash for the difference between the contracted price and the actual price on the
expiration date.
 Futures contracts are generally standard- ized instruments that are traded on exchanges,
whereas forward contracts are

Future/Hedging/Swap

Futures are used for both speculation and hedging. Speculation involves betting on future price
movements, and futures are used because of the leverage inherent in the contract. Hedging, on the
other hand, is done by a firm or an individual to protect against a price change that would otherwise
negatively affect profits. For example, rising interest rates and commodity (raw material) prices can hurt
profits, as can adverse currency fluctuations. If two parties have mirror-image risks, they can enter into a
transaction that eliminates, as opposed to transfers, risks. This is a “natural hedge.” Of course, one party
to a futures contract could be a speculator and the other a hedger. Thus, to the extent that speculators
broaden the market and make hedging possible, they help decrease risk to those who seek to avoid it.

There are two basic types of hedges:

(1) long hedges, in which futures con- tracts are bought in anticipation of (or to guard against) price
increases, and
(2) short hedges, where a firm or an individual sells futures contracts to guard against price declines.
Recall that rising interest rates lower bond prices and thus decrease the value of T-notes futures
contracts. Therefore, if a firm or an individual needs to guard against an increase in interest rates, a
futures contract that makes money if rates rise should be used. That means selling, or going short, on a
futures contract.
Swap
A swap is just what the name implies—two parties agree to swap something,
generally obligations to make specified payment streams. Most swaps today
involve interest payments or currencies.