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Forward and Futures Markets Forward and Futures Markets such as t, F, and χ2, are used in hypothesis testing as a FORWARD AND means of evaluating the likelihood that an observed pat- FUTURES MARKETS tern of results is attributable to chance. This likelihood is Futures markets and forward markets trade contracts that reflected in the p-values that accompany observed values determine a current price for a commodity transaction of test statistics, with values lower than .05 indicating, by designated to take place at a later date. Despite being fun- convention, statistical significance. damental to financial and commodity trading, there is A related use of formulas is for the computation of some confusion over the precise definition of futures and effect sizes, which are means of indexing the practical, as forward contracts. While common usage sometimes opposed to statistical, significance of a research finding. A defines futures and forwards as synonyms, a futures con- frequently used effect size, d, is attributable to the tract is a specialized form of forward contract that is stan- American psychological researcher Jacob Cohen. The for- dardized and traded on a futures exchange. As such, a mula for computing d is: technical distinction is required between futures markets M ϪM and forwards markets. Some forward contracts, such as 1 2 . ␴ those traded on the London Metals Exchange, have many features of futures contracts. Other types of forward con- Here, M1 and M2 are means on some outcome for tracts are more complicated, such as the forward contract- σ two groups and is a standard deviation, either for one of ing provisions embedded in long-term oil delivery the groups or for a “pooled” standard deviation. The contracts. While it is tempting to claim that futures con- resultant value is the difference between the two groups in tracts represent an evolution of forward trading, much standard deviation units, which is interpreted with refer- twenty-first-century progress in contract design has come ence to criteria for small, medium, and large effects, as in over-the-counter (OTC) trading, the primary venue for described by Cohen. Other effect sizes can be generated many types of forward contracting. using formulas specific to the statistical model used to analyze the data. HISTORY OF FORWARD AND Mathematical reasoning is a routine activity in quan- FUTURES CONTRACTS titative social science research. At the most fundamental The history of forward contracts can be traced back to level, mathematical formulas are, in some instances, used ancient times. Due to the difficulties of transport and to define and predict variables. In all cases, mathematical communication, trading based on samples was common formulas are used to construct test statistics required for and some form of forward contracting was essential. The hypothesis testing. Increasingly, these test statistics are contracting process usually involved only the producers accompanied by effect sizes, which make use of output and consumers of the goods being traded. During the six- from statistical analyses to construct indexes of practical teenth century, liquidity of forward markets was substan- significance. For these reasons, social scientists routinely tially increased by the emergence of the Antwerp bourse. use mathematical reasoning in their work. By the mid-seventeenth century, forward markets had SEE ALSO Methods, Quantitative; Models and Modeling; developed to where the Amsterdam bourse featured both Quantification; Social Science; Statistics; Statistics in forward and option contracts for commodities, such as the Social Sciences wheat and herring, and for foreign stocks and shares. The beginning of trade in futures contracts is usually traced to mid-nineteenth-century Chicago, where the Board of BIBLIOGRAPHY Trade—founded in 1848—transacted the first “time con- Adams, J. Stacey. 1963. Toward an Understanding of Inequity. tract” in 1851. The grain trade of that era typically Journal of Abnormal and Social Psychology 67: 422–436. involved merchants at various points along major water- Cohen, Jacob. 1988. Statistical Power Analysis for the Behavioral ways purchasing grain from farmers which was then held Sciences. 2nd ed. Mahwah, NJ: Erlbaum. in storage, often from fall or winter into spring. In order Kelley, Harold H., and John Thibaut. 1978. Interpersonal to avoid the risk of price fluctuation and to satisfy Relations: A Theory of Interdependence. New York: Wiley- bankers, merchants started going to Chicago to transact Interscience. contracts for future, spring delivery of grain. The con- Rusbult, Caryl E. 1980. Commitment and Satisfaction in tracts set a price for delivery of a standardized grade at a Romantic Associations: A Test of the Investment Model. later delivery date. While these early contracts were simi- Journal of Experimental Social Psychology 16: 172–186. lar to modern futures contracts, some terms and condi- tions of these time contracts were specific to the original Rick H. Hoyle parties to the transaction, as with a forward contract. 180 INTERNATIONAL ENCYCLOPEDIA OF THE SOCIAL SCIENCES, 2ND EDITION Forward and Futures Markets THE FUTURES CONTRACT AND to prevent the contract from being closed out. On the THE FUTURES EXCHANGE other hand, settlement on forward contracts usually A significant difference between futures and forward con- occurs by delivery of the commodity at the maturity of the tracts arises because futures contracts are legally required contract. Hence, futures contracts have cash flow implica- to be traded on futures exchanges while forwards are usu- tions during the life of the contract while forwards usually ally created by individual parties operating in the decen- do not. tralized OTC markets. Because a futures contract is transacted on an exchange, the traders originating the MODERN USAGE OF FORWARD contract use the exchange clearinghouse as the counter- AND FUTURES CONTRACTS party to their trade. While both a short trader (seller) and In modern markets, considerable variation is observed in long trader (buyer) are required to create a futures con- the relative use of forward or futures contracting across tract, both traders execute the trade with the clearing- commodity markets. For example, in currency markets, house as the direct counter-party. This allows a futures the large value and volume of many individual trades has contract to be created without the problems associated the bulk of transactions for future delivery conducted in with forward contracting, which typically depends on the the currency forward market. Exchange traded currency creditworthiness of the counter-party. By design, futures futures contracts are an insignificant fraction of total trad- contracts are readily transferable via the trading mecha- ing volume in the global currency market. As trading in nisms provided by the exchange. Because forward con- forwards is closely integrated with cash market transac- tracts depend on the performance of the two original tions, direct trading in forward contracts is restricted to parties to the contract, these contracts are often difficult the significant spot market participants, effectively the to transfer. One practical implication of this difference is largest banks and financial institutions. Because currency that if a futures trader wants to close out a position, an forward contracts do not have regular marking to market, equal number of offsetting contracts for that commodity restricted participation is needed to control default risk. month is transacted and the original position is cancelled. As such, differences in the functioning of futures and for- Forward contracts are usually offset by establishing ward markets impacts the specific method of contracting another forward contract position with terms as close as selected for conducting commodity transactions. For possible to those in the original contract. Unless the for- example, in contrast to forward trading, futures markets ward contract provides a method for cash settlement at are designed to encourage participation by large and small delivery, this will potentially involve two deliveries having speculative traders. The increased participation of specu- to be matched in the cash market on the delivery date. lators not directly involved in the spot market provides an To facilitate exchange trading, futures contracts pos- important source of additional liquidity to futures mar- sess a number of key features, especially standardization kets not available in forward markets. In order to achieve and marking to market. The elements of standardization this liquidity certain restrictions are imposed on trading, provided by the futures contract and by the rules and reg- such as limits on position sizes and the imposition of fil- ulations of the exchange governing such contracts involve: ing requirements. By restricting participation to large the deliverable grade of the commodity; the quantity players in the commodity market, many of the restrictions deliverable per contract; the range of quality within which required for the functioning of futures markets are not delivery is permissible; the delivery months; and, the present in forward markets. options associated with the specific grade and date of delivery that is permissible. Standardization is achieved by SEE ALSO Bubbles; Bull and Bear Markets; Contango; making each futures contract for a given commodity iden- Discounted Present Value; Equity Markets; tical to all other contracts except for price and the delivery Expectations;
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