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The definition of a forward or future is very similar and the resulting cashflows are identical. There are some technical differences explained in section 5.1 but for now we shall consider them as one.

As the name implies, a future is a product that will result in an exchange of assets sometime in the future, although the price and amount is agreed now. Also, the trade is legally binding as from now. It is very similar to a spot trade with a very long settlement period. Since the agreed price now and the prevailing market price at time of exchange may be different, both parties will have to come to an agreement for the fair price of the product, taking into account expected future prices.

Futures can be physical or cash settled as shown in Figures 3.2 and 3.3 respectively. Physical settlement means an actual exchange of cash for asset at the future time. Cash settlement means that at settlement, we take the difference between the prevailing market price and the price at which the trade was agreed and one party pays that cash difference to the other.

Figure 3.2 Cashflows on physical future trade

Figure 3.2 shows a physical futures exchange. We agree now that at a future time (known as the future settlement date), we will pay cash and receive a fixed amount of a commodity. All the exchanges are therefore known from now.

Figure 3.3 Cashflows on cash future trade

However a cash settlement future works differently. Suppose we agree now to buy 1m troy ounces of gold from Commerzbank at USD 1000 per troy ounce for cash settlement in six months from today. If, in six months' time, gold was trading at USD 1010 per troy ounce, Commerzbank would owe us:

They would pay USD 10m in cash and no gold would change hands.

If, on the other hand, the price in six months fell to USD 994, we would have to pay: