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Forward Contract
Forward is just a contract to deliver at a future date (exercise date or maturity date) at a specified exercise price. Example: Rice farmer sells rice to warehouser. Example: Foreign Exchange (FX) forward. Contract to sell for . Both sides are locked into the contract, no liquidity. What will warehouse think if rice farmer tries to get out of the contract?
Futures Contracts
Futures contracts differ from forward contracts in that contractors deal with an exchange rather than each other, and thus do not need to assess each others credit. Futures contracts are standardized retail products, rather than custom products. Futures contracts rely on margin calls to guarantee performance.
Daily Settlement
Every day, the exchange defines a price called the settle price, which is essentially the last trade on that day. Every day until expiration a buyers margin account is credited (or debited if negative) with the amount: change in settle price contract amount If contract is cash settled, on the last day the margin account is credited with (cash settle pricelast settle price)contract amount. If contract is physical delivery, on last day buyer must receive commodity
Basis Risk
Basis risk = risk that Iowa corn prices will not match Chicago settle prices Option of physical delivery in the corn contract means that arbitrageurs will keep basis risk down. Arbitrageurs may load corn in Iowa and ship to Chicago if Iowa price is below Chicago price. Arbitrageurs activity means farmers dont have to ship to Chicago.
(See http://www.indexarb.com)
September 4
Spot 232 Sept future 233 Spot premium 1 Basis 1 Gain of 2 (reflects gain in premium)
December 1
252 252 0 Gain of 5 3/4
July 1
Spot No. 2 218 1/2 July future 225 Spot premium 6 Loss of 24 1/2