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speculator would suffer losses equal to the difference between the forward price and the spot price.
For example, suppose the initial spot price is $3 per bushel, and the forward price is $3.50 per bushel.
If the spot price upon expiration is $4.50 per bushel, the long speculator would earn a profit of $1 per
bushel. The profit is the terminal spot of $4.50 minus the $3.50 initial forward price. If, alternatively,
the terminal spot price is $3.25, the speculator would lose 25 cents per bushel—that is, $3.25 minus
$3.50. Notice that the $3 initial spot price is irrelevant in both cases.
Speculators play important roles in the derivatives markets. First, speculators provide liquidity. If
farmers wish to short forward contracts but there are no bakers around who want to go long,
speculators will step in and offer to take the long side when the forward price is bid down low enough.
Similarly, they will take the short side when the forward price is bid up high enough. Speculators also
bring information to the marketplace. The existence of derivatives contracts and the promise of
speculative profits make it worthwhile for speculators to devote resources to forecasting weather
conditions, crop yields, and other factors that impact prices. Their forecasts are made known to the
public as they buy or sell futures and forwards.
Futures
Futures contracts are closely related to forward contracts. Like forwards, futures are contracts that
spell out deferred transactions. The long party commits to buying some underlying asset, and the short
party commits to sell. The differences between futures and forwards are mainly technical and
logistical. Forward contracts are custom-tailored, over-the-counter agreements, struck between two
parties via negotiation. Futures, alternatively, are standardized contracts that are traded on exchanges
between parties who probably do not know each other. The exact quantity, quality, and delivery
location can be negotiated in a forward contract, but in a futures contract the terms are dictated by the
exchange. Because of their standardization and how they are traded, futures are very liquid, and their
associated transaction costs are very low.
Another feature differentiating futures from forwards is the process of marking to market. All day
and every day, futures traders meet in trading pits at the exchanges and cry out orders to buy and sell
futures on behalf of clients. The forces of supply and demand determine whether futures prices rise or
fall. Marking to market is the process by which at the end of each day losers pay winners an amount
equal to the movement of the futures price that day. For example, if the wheat futures price at
Monday‟s close is $4.00 per bushel and the price rises to $4.10 by the close on Tuesday, the short
party must pay the long party 10 cents per bushel after trading ends on Tuesday. If the price has fallen
10 cents, then long would pay short 10 cents per bushel. Both long and short parties have trading
accounts at the exchange clearinghouse, and the transfer of funds is automatic. The purpose of
marking to market is to reduce the chance of default by a party who has lost substantially on a futures
position. When futures are marked to market, the greatest possible loss due to a default would be an
amount equal to one day‟s price movement.
As mentioned, futures are marked to market every day. When the contract expires, the last marking
to market is based on the spot price. For example, suppose two days prior to expiration the futures
price is $4.10 per bushel. On the second to last day the futures price has risen to $4.30. Short pays
long 20 cents per bushel. Suppose at the end of the next day, the last day of trading, the spot price is
recorded at $4.55. The last mark-to-market payment is from short to long for 25 cents per bushel,
equal to the difference between the spot price upon expiration and the previous day‟s futures price.