Options, futures and forwards all present opportunities to lock in future prices for securities, commodities, currencies or other assets. These instruments, known as derivatives, allow investors to hedge their price risk, or to speculate on price movements. The key difference is that options represent opportunities, while forwards and futures represent obligations. Meanwhile, forwards and futures differ from each other in their technical details.
An option gives the holder the right to either buy or sell a specific quantity of something at a specific price at a future date. The "something" can be shares of stock, bushels of corn, units of currency or whatever else the parties to the contract want to deal with. The quantity, price and date are spelled out in the option contract. The defining characteristic of an option is that the option holder isn't required to go through with the transaction. If the "strike price" in the contract isn't favorable, the holder can let the option expire without exercising it.
Futures and Forwards
Futures and forwards work like options, except that the parties to the contract are obligated to go through with the transaction. If you hold an option to buy 1,000 bushels of corn at $5 a bushel and the market price is only $4, then you can simply choose not to exercise the option. If you hold a futures or forward contract for the same thing, you'll be stuck buying the overpriced corn, unless you can sell the contract to someone else. The difference between forwards and futures hinges on technical details.
Negotiating and Trading
Futures contracts are traded through exchanges, such as the Chicago Mercantile Exchange, the world's largest derivatives exchange. As a result, when you buy futures, you don't know who's on the other end of the transaction -- and it doesn't really matter, because the exchange itself bears the default risk. That means that if the "counterparty" to your futures contract doesn't live up to his obligations, the exchange makes sure you get taken care of. Forwards, by contrast, trade "over the counter," meaning they're negotiated directly between the two parties. The parties themselves bear the default risk. Because futures trade on exchanges, their terms are standardized. Forwards, on the other hand, are completely flexible; the parties can set the terms however they want.
Futures contracts are designed to minimize credit risk to the parties -- the risk that at the time the contract comes due, the market price of the underlying asset will have changed so much that one party or the other won't have the money to make good on it. They do this through "marking to market" and "margining." Each day, the value of the futures contract gets marked to market -- adjusted to account for changes in the market price of the underlying asset. The parties to the contract then exchange payments based on which side has gained or lost value that day. (The process is all automated.) These payments, called margins, essentially reset the net value of the contract to zero. Forwards don't have any margining. Full payment is due at settlement and each party bears the credit risk.
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