Learn about and see examples for futures and forward agreements.
- Would you have been a fortuneteller in a pre-industrialized society? If not, and if you don't have a working crystal ball, then you might want to lock in your future commodity price risks using commodity futures contracts or forward agreements. Locking in commodity prices in the future allows for future financial transactions that reduce risk. There are two kinds of agreement you can use. Futures contracts, which are on an exchange and standardized. And forward agreements, which are off-exchange and customized.
Commodity futures contracts and forward agreements do not require cash outlays upfront. These contracts allow for terms to buy or sell a commodity at some time in the future, and are often used for hedging purposes to manage risks. This applies to energy, agricultural, and metals commodities. Futures are financial contracts with standardized set terms for a commodity that obligates a buyer to purchase the asset, or the seller to sell that asset.
Futures exist for physical commodities and financial instruments. Common examples of futures contracts are for crude oil, copper, and cotton. Futures contracts are traded on exchanges. Some of the exchanges you may have heard of include the New York Mercantile Exchange, or the NYMEX, where natural gas and crude oil futures are traded. Also, there's the commodity exchange, or the COMEX, where copper futures are traded. Futures contracts include standardized terms of the commodity involved.
These terms include quantity, quality, and sometimes geography. In terms of quantity, futures always include terms that state the amount or volume of goods involved. Like the numbers of barrels of oil, the pounds of aluminum, or the bushels of corn. For instance, an oil driller usually sells oil futures at a fixed price to lock in the sale price of crude oil. And a refinery buys those futures at a fixed price to lock in future costs of oil.
Additionally, a corn farmer would sell futures at a fixed future price to lock in the sale price of corn, while a cereal company would buy them to lock in the purchase price of corn. As for quality, futures contracts also usually include details about the assets involved. This might include gold B 999 fine, or 99.9% pure which is a trading term for 24 karat gold. Or for crude, it might require to have a certain amount of sulfur and gravity.
Which are important chemical attributes. And for geography. Some futures contracts require physical settlement, while others are settled financially. Let's take the two main traded crude oil contracts. US West Texas Intermediate Crude Oil, WTI futures, and British North Sea Brent Crude Oil futures. WTI is physically settled, and WTI futures require that contract buyers receive physical crude oil at Cushing, Oklahoma.
If the contract expires and you own it, you're going to get a call to come get your oil. But not everyone wants that physical risk. This is why Brent Crude Oil futures can be financially settled. And these contracts do not require buying physical crude oil in the North Sea. You don't have to sport a kilt and show up in Scotland to come get your crude oil. It's all financially settled. One big thing to know about futures is that they are settled on a daily basis. And daily settlement reconciliation can have significant and potentially negative cash flow implications.
Forward agreements perform a similar function to futures. But they are different, because they are customized, off-exchange agreements for one party to buy an asset from another party at some time in the future. These contracts are not settled on a daily basis, but there can be margin requirements. And every aspect of the agreement can be customized including quantity, quality, geography, and other terms as well. Some of the examples I've seen of forward agreements have been instead of NYMEX WTI Crude Oil at Cushing, an agreement for jet fuel at a certain airport was created.
Instead of an agricultural contract on an exchange, something like cotton, an agreement for strawberries was created. Instead of a metals contract for gold, an agreement for industrial diamonds was created. As you can see, these are all a bit more unusual contracts, and they required forward agreements because the customization of forward agreements is the number one differentiating factor from standardized futures contracts. Essentially, if there is an energy, metals, or agricultural commodity out there, and it isn't on an exchange, someone somewhere, or more specifically, to someone somewhere, probably have a forward agreement in place to manage that more exotic and non-standardized risk.
Futures and forwards are widely used risk management solutions. Does your company have any commodity risks that could be managed with standard futures contracts? Or does your company have more exotic risks that might require a customized forward agreement?
Jason Schenker of Prestige Economics discusses nine types of corporate risk, including financial and nonfinancial risks. He explains the difference between direct risks that companies face constantly, as well as indirect risks that usually come from vendors, competitors, and counterparties. Then he covers how risks are typically resolved, either by elimination (divestiture or acquisition), transfer (hedging or insuring), offset (creating a natural hedge), or ownership (keeping the exposure). Finally, he reviews how corporations can actively measure and monitor risk by appointing dedicated risk managers, officers, and committees.
- Understanding risk in corporations
- Risk management process
- Nine different types of corporate risks
- Financial market risks
- Direct and indirect risks
- Risk management solutions
- How corporations actively manage risk