The futures market is a key segment of the global financial derivatives ecosystem where contracts derive value from an underlying asset such as commodities, stocks, currencies, or bonds. It evolved from forward contracts, which were originally used by businesses to lock prices and manage future uncertainty.
This concept matters because companies, traders, importers, exporters, and investors rely on forward and futures contracts to protect themselves from price volatility. These instruments help in risk management, price discovery, and financial planning across industries.
Understanding forward contracts is essential to fully grasp how the futures market functions today, especially in fast-growing derivatives markets like India.
What Happened in the Evolution of the Forwards and Futures Market
Forward contracts are among the oldest financial derivatives, with references dating back to 320 BC in Kautilya’s Arthashastra. In ancient India, similar agreements were used to fix crop prices before harvest, allowing farmers to receive advance payments and reduce income uncertainty.
Over time, these private agreements evolved into structured financial instruments. While forward contracts remained over-the-counter (OTC) agreements between two parties, futures contracts became standardized and exchange-traded, making them more transparent and liquid.
Today, forward contracts are still widely used by banks, commodity importers, exporters, and large corporations, while futures dominate exchange-traded derivatives markets.
Why Forward Contracts Form the Foundation of the Futures Market
A forward contract is a derivative where two parties agree today on the price of an asset that will be bought or sold on a future date. The asset can be crude oil, gold, currency, agricultural products, or financial securities.
The core idea is price locking. The buyer wants protection from rising prices, while the seller wants protection from falling prices. This mutual agreement creates a hedge against future market volatility.
This simple structure became the base on which modern futures contracts were designed, with added regulation, liquidity, and risk management systems.
A Real-World Forward Contract Example Using Crude Oil Importers
Consider a realistic business scenario in the energy sector. Suppose an Indian oil refinery expects to import crude oil after three months and is worried that global crude prices may rise due to supply disruptions or geopolitical tensions.
On 1st January 2026, ABC Refinery enters into a forward agreement with XYZ Oil Suppliers to purchase 1,00,000 barrels of crude oil at $80 per barrel, with delivery scheduled on 1st April 2026. The total contract value is fixed at $8 million at the time of agreement.
This agreement is executed in the OTC market, meaning it is privately negotiated between the refinery and the supplier without any exchange involvement or standard contract specifications.
How Price Movements in Forward Contracts Impact Buyers and Sellers
There are three possible outcomes when the contract reaches its settlement date, depending on how the crude oil price moves in the global market.
Scenario 1: Crude Oil Prices Rise
If crude oil prices rise to $95 per barrel by 1st April 2026, ABC Refinery benefits significantly. The market value of the oil becomes $9.5 million, but the refinery still pays only $8 million as per the fixed contract.
This results in an effective saving of $1.5 million for the refinery, while XYZ Oil Suppliers face a financial disadvantage as they are obligated to sell below the prevailing market price.
Scenario 2: Crude Oil Prices Fall
If crude oil prices fall to $70 per barrel on the settlement date, the situation reverses. The market value of the oil drops to $7 million, but ABC Refinery must still buy at the agreed price of $80 per barrel.
In this case, the refinery incurs a notional loss of $1 million, while XYZ Oil Suppliers gain by selling at a higher fixed price than the open market rate.
Scenario 3: Crude Oil Prices Remain Stable
If crude oil prices remain at $80 per barrel on the settlement date, neither party gains nor loses financially. The contract simply fulfills its purpose of price certainty and risk management.
Settlement Methods in Forward Contracts and Their Financial Impact
Forward contracts can be settled through physical settlement or cash settlement. In physical settlement, the seller delivers the actual underlying asset, such as crude oil, commodities, or goods, and the buyer pays the full agreed contract value.
In cash settlement, instead of delivering the asset, both parties exchange only the price difference. For example, if oil rises from $80 to $95 per barrel, the supplier may pay the $1.5 million difference to the refinery without actual delivery.
Cash settlement is widely preferred in modern financial markets because it reduces logistical costs and simplifies execution.
Bigger Context Behind Forward Contracts in the Financial Derivatives Market
Financial derivatives are instruments whose value is derived from an underlying asset. The global derivatives market includes forwards, futures, options, and swaps, with futures and options accounting for a majority of exchange-traded volumes.
In India, derivatives trading contributes over 90% of total trading volume on major exchanges like NSE, showing the growing importance of risk management tools in modern investing and corporate finance.
Forward contracts continue to play a crucial role in international trade, currency hedging, commodity imports, and corporate risk management despite the rise of standardized futures markets.
Key Risks in Forward Contracts Compared to Futures Contracts
One major limitation of forward contracts is liquidity risk. Since they are private agreements, finding a counterparty with an exact opposite market view is often difficult.
Another significant concern is counterparty or default risk. If market prices move sharply, one party may refuse or fail to honor the contract due to financial losses.
Forward contracts also face regulatory risk because they are not governed by centralized exchanges or clearing corporations. Their rigid structure makes early exit or modification difficult compared to exchange-traded futures.
How the Futures Market Solves the Problems of Forward Contracts
Futures contracts were developed to overcome the weaknesses of forward agreements. They are standardized, regulated, and traded on exchanges, ensuring transparency and higher liquidity.
Unlike forwards, futures are backed by clearing houses that reduce default risk through margin requirements and daily mark-to-market settlement. This makes them safer for institutional and retail participants.
Due to these advantages, futures have become the preferred derivative instrument in equity, commodity, and currency markets globally.
What Happens Next in the Growth of Futures and Derivatives Markets
With rising global volatility in commodities, currencies, and equities, demand for hedging instruments is increasing. Businesses and investors are increasingly using derivatives to manage financial risks.
India’s derivatives market is expected to expand further as financial literacy improves and more retail investors participate in futures and options trading. Regulatory oversight and technological advancements are also strengthening market efficiency.
The evolution from forward contracts to futures markets represents a major shift toward safer, more liquid, and regulated financial risk management systems.
Frequently Asked Questions
What is a forward contract in the derivatives market?
A forward contract is a private OTC agreement where two parties agree to buy or sell an asset at a fixed price on a future date.
How is a futures contract different from a forward contract?
Futures contracts are standardized and traded on exchanges, while forward contracts are customized and privately negotiated between two parties.
Why do companies use forward contracts?
Companies use forward contracts to hedge against price volatility in commodities, currencies, and raw materials, ensuring cost certainty in future transactions.
What are the biggest risks in forward contracts?
The main risks include counterparty default risk, low liquidity, lack of regulation, and contractual rigidity compared to exchange-traded futures.
Conclusion
Forward contracts laid the foundation of the modern futures market by introducing price locking and hedging mechanisms for future transactions. While they remain important in OTC markets for customized agreements, their limitations in liquidity, flexibility, and regulation led to the rise of standardized futures trading. As financial markets grow more complex, futures contracts continue to dominate derivatives trading due to their transparency, safety, and efficiency.
BBW News Desk is the editorial team of BigBreakingWire, a digital newsroom focused on global finance, markets, geopolitics, trade policy, and macroeconomic developments.
Our editors monitor government decisions, central bank actions, international trade movements, corporate activity, and economic indicators to deliver fast, fact-based reporting for investors, professionals, and informed readers.
The BBW News Desk operates under the editorial standards of BigBreakingWire, prioritizing accuracy, verified information, and timely updates on major global developments.
Be First to Comment