Question

Researchers found that it is very difficult to forecast future exchange rates more accurately than the forward exchange rate or the current spot exchange rate. What are the underlying factors behind these findings?

Answer 1

Forward Contracts vs. Futures Contracts: An Overview

Both forward and futures contracts involve the agreement to buy and sell assets at a future date. A forward contract, though, settles at the end of the contract, while the settlement for a futures contract happens on a daily basis.Both contracts fundamentally have the same function, however, the specific details of each are different.

• The forward contract is used primarily by hedgers who want to cut down the volatility of an asset's price, while futures are preferred by speculators who bet on where the price will move.

Forward Contracts

The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract.

These contracts are private agreements between two parties, so they do not trade on an exchange. Because of the nature of the contract, they are not as rigid in their terms and conditions.

Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So if two parties agree to the sale of 1000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.

A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.

A futures contract — often referred to as futures — is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset — usually stocks, bonds, or commodities, like gold.

The main differentiating feature between futures and forward contracts — that futures are publicly traded on an exchange while forwards are privately traded — results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.

Comparison chart

Forward Contract versus Futures Contract comparison chart

	Forward Contract	Futures Contract
Definition	A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a specified price.	A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.
Structure & Purpose	Customized to customer needs. Usually no initial payment required. Usually used for hedging.	Standardized. Initial margin payment required. Usually used for speculation.
Transaction method	Negotiated directly by the buyer and seller	Quoted and traded on the Exchange
Market regulation	Not regulated	Government regulated market (the Commodity Futures Trading Commission or CFTC is the governing body)
Institutional guarantee	The contracting parties	Clearing House
Risk	High counterparty risk	Low counterparty risk
Guarantees	No guarantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid	Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.
Contract Maturity	Forward contracts generally mature by delivering the commodity.	Future contracts may not necessarily mature by delivery of commodity.
Expiry date	Depending on the transaction	Standardized
Method of pre-termination	Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty.	Opposite contract on the exchange.
Contract size	Depending on the transaction and the requirements of the contracting parties.	Standardized
Market	Primary & Secondary	Primary

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That's because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.

Futures Contracts

Like forward contracts, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract.

First, futures contracts—also known as futures—are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of dates.

Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.

The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

therefore it becomes very difficult to forecast future exchange rates more accurately than the forward exchange rate or the current spot exchange rate.