Futures, Forwards and Contracts
A financial contract is a legally enforceable agreement to buy, lend, swap, repurchase or any other arranged transaction between two parties in a financial market. The arrangements are under the financial law which governs rights and duties arising thereby. The parties involved typically transact in securities, currencies, interest rates or any other rates, commodities and other financial assets between two parties participating in a financial market. They are also referred to as hedging instruments against risks. They are mostly entered after a request from a counterparty seeks quotation or bid. The contracts may differ in many ways.
Futures
They are agreements to buy or sell financial assets for a future date at a specific agreed price. The daily charges of the figures are settled day by day until the contract comes to an end. Since they are marked to the market daily, they can be bought or sold at any time. They are also traded on a standardized exchange which allows them to have clearinghouses. The clearing houses provide regulation and oversight for the fulfilment of obligations. Therefore, there is a guarantee of no default at all, or it has a low probability of occurring (low risk). The markets for future contracts are highly liquid. The liquidity gives investors the ability to enter and exit at any time they choose. Future contracts are traded on public exchanges (Hull, 2019).
Forwards
These are also contracts between a buyer and a seller to trade in a financial asset at a future date at a specific agreed price and a specified (maturity/ expiration) date. The buyers or the sellers are to fulfil (settle) their obligations at the maturity date. The prices are set at the time when the contract is being drawn. The agreements are private and not standardized. Therefore, they are not traded on public exchanges. They are not very rigid in their terms and conditions because of the nature of the contract. The latter also does not allow them to be available to retail investors. Their market is difficult to predict because the details are only between the buyer and the seller and not the public. Their private nature makes them be highly risky; one party may default (Shimko, 2016).
Options
These are contracts that give the buyer the right although not an obligation to buy or sell an underlying asset by a specified date (expiration date) and a specified price (strike price). They are usually traded online or through brokers. The sellers of the options are called the writers. They differ from the futures in that the holder of the asset have a choice to buy or sell an asset if they want. They are mainly of two types: calls and puts. Call options allow the holder to buy the asset at a stated (strike) price within a specific timeframe specified in the option contract. Investors purchase the calls when they predict that the value of the underlying asset will increase and sell if they expect a price decrease (Jarrow and Oldfield 2015).
On the other hand, put options give the buyer the right and no obligation to sell the underlying asset at the strike price and specified timeframe drawn in the contract. Investors will buy puts after speculation of a price decrease of the underlying asset and sell if they predict the price will increase. Each of the contracts has an expiration date in which the holder of the asset must exercise their option. The buyer usually pays for the options premiums so that the rights can be binding to the contract.
References
Hull, J. C. (2019). Options futures and other derivatives. Pearson Education India.
Jarrow, R. A., & Oldfield, G. S. (2015). Forward contracts and futures contracts. Journal of Financial Economics, 9(4), 373-382.
Shimko, D. C. (2016). Options on futures spreads: Hedging, speculation, and valuation. Journal of Futures Markets, 14(2), 183-213.