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Solomon Neuhardt on the forwards and futures market – part 1

Futures markets are a rarely discussed financial concept for the layperson. They are traded on the Chicago Mercantile Exchange. Futures contracts are a method to create prices for agricultural products. In finance, a futures Contract (more colloquially, futures) is a contract between two parties to buy or sell an asset for a price agreed upon today (the futures price) with delivery and payment occurring at a future point, the delivery date.

The first futures markets were in Osaka, Japan. More specifically, Dojima, Japan in the 1600s. At that time, Dojima was the rice center for the Far East. Futures markets started for agricultural products. Most such products are harvested just one time a year. Contracts are usually signed to buy a product at a future date. By contrast, a “spot contract” is where a person wants to buy a product on the spot or immediately. The reason that the futures market was created was because a buyer of rice, for example, would have to travel to many warehouses to compare prices.

The trading floor in Dojima became so noisy from the traders talking or shouting that the traders started using hand signals to communicate buys or sells of contracts. The hand signals continued to be used in futures markets around the world.

The purpose also of the development of the original futures market was to standardize the price for different types of rice. A particular type of rice was selected as the standard. Also, there were experts at the market who could test the types of rice.

There is no exchange for forwards contracts so they are not traded as frequently however they are still important. Forwards are more difficult to follow because they don’t have a common market that you can follow on CNBC, for example. Furthermore, futures contracts are very liquid and you can buy or sell them with relative ease whereas forwards contracts are not.

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Furthermore, delivery dates and locations were standardized in the futures markets. In the 1600’s, a delivery location was a warehouse. The trading floor in Ojima, like modern day markets, only operated during certain hours of the day. The method for closing the floor was to light a flame and when the flame burned the trading floor was closed. Now we have clocks instead of flames. http://www.amazon.com/Trading-Commodities-Financial-Futures-Step-/dp/0134087186/ref=sr_1_1?s=books&ie=UTF8&qid=1445814743&sr=1-1&keywords=futures

In a futures contract, you do not know who the other party is to the contract. In a forward market by contrast, you know who the party is who is buying your grain, for example. In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument.

There is no “counterparty risk” in buying a futures contract, because the exchange guarantees the contract (unless you are worried about the exchange itself).

An example of a forward contract is if you are selling cars in Japan and you expect to receive Yen in three months and you are concerned about fluctuation in currency prices. You can buy a forward exchange rate contract to control this risk.

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