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.