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  • 8.9.5-FUTURES MARKETS-DIFFERENCES BETWEEN FORWARD AND FUTURES MARKET PRICES

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  • Differences between forward and futures market prices

     
     

    Forward markets are used to contract for the physical delivery of a commodity. By contrast, futures markets are 'paper' markets used for hedging price risks or for speculation rather than for negotiating the actual delivery of goods. On the whole, prices in the physical and the futures markets move parallel to each other. However, whereas the futures price represents world supply and demand conditions, the physical price for any particular coffee in the forward market reflects the supply and demand for that specific type and grade of coffee, and the nearest comparable growths.

    Prices in both physical and futures markets tend to move together because traders in futures contracts are entitled to demand or make delivery of physical coffee against their futures contracts. The important point is not that delivery actually takes place but that delivery is possible, whether this course of action is chosen or not. Any marked discrepancy between the prices for physicals and futures would attract simultaneous offsetting transactions in the two markets thus bringing prices together again.

    However, buying futures in the hope of using the coffee against physical delivery obligations is extremely risky because the buyer of futures contracts does not know the exact storage location or the origin or quality of the coffee until delivery is made. The coffee that is finally delivered may be unsuitable for the buyer's physical contractual obligations, leaving them with more rather than less risk exposure. On the other hand, physical coffee on a forward shipment or delivery contract that is of an acceptable quality can usually be delivered against a short position on the futures market as the buyer can choose the origin and where to make the physical delivery (or tender). This feature makes futures contracts particularly suitable as a hedge against physicals.