What does the future hold for investors? What will happen going forward? Unfortunately there is no crystal ball to give us an answer.

However there are signals in the financial markets provided by futures and forward contracts. These are contracts that are used to lock in future prices or rates. They are available in a variety of forms for both institutional and individual investors. The current prices for those futures or forwards today can provide an indication of what investors think will happen.

Forward contracts are utilised by institutional investors. These are larger customised contracts between two institutions.

The contracts are of significant sums, typically in the millions. Forwards originated in the commodities markets, where producers tried to lock in the prices of their products.

For example, a farmer producing grain would lock in a price in the spring for his harvest in the fall by selling a forward. While a producer of bread would lock in a price for wheat by agreeing to buy it at that forward price in the future.

The thing to watch with commodity futures is that the buyer may have to take delivery of the underlying commodity when the contract expires, be it wheat, pork bellies, gold or silver. The focus of today's forward market for financial institutions is on currencies and interest rates.

These contracts are traded through intermediary banks between two parties. They are used for hedging purposes to minimise the risk of large changes in the value currencies or in the interest rates.

For example, an insurance company in Bermuda may write a policy to cover a significant risk in Europe. The insurance company may choose to hedge any currency risk by buying a forward contract in euros to cover any currency exposure if they have to payout in euros on the policy.

They would contact an intermediary bank such as HSBC in Bermuda to buy a forward in euros issued by a counterparty overseas. Only a transaction fee is paid at inception of most forward contracts.

Who pays the contract at expiration will depend on the change in value. If euros rose in value, the counterparty would pay our insurance company.

A very common use of forwards in addition to currencies is for interest rates, wherein there can be payments made during the course of the contract.

For example, if a company holds variable rate debt, they may want to lock in an interest rate if they think rates are climbing. That company would look to buy a fixed rate forward contract.

A second company may prefer to accept the variable rate and will agree to pay a fixed rate in exchange for variable rate payments from the first company.

At predetermined intervals over the term of the agreement, the two parties would exchange money based on changes in the interest rates. If rates went up, the second party would pay the first.

Another common type of contract for interest rates is known as a "repo" or repurchase agreement. Here one institution would agree to sell a contract to another company and agree to repurchase it in the future at a higher price. The repo rate is based on the difference in price from the sale and repurchase price.

Forward contracts are large institutional contracts, customised between two parties. As such, there is a reliance on the other party to pay when due. This is counterparty risk.

There is no one guaranteeing that the contract will be paid. Therefore, it is important to gauge the financial strength and reliability of the counterparty.

Also, there is no secondary market in forwards because they are customised for specific purposes. However, a forward commitment can be closed-out early by buy or selling an offsetting contract.

For example, the insurance company that bought the Euros contract through HSBC would in turn sell an offsetting contract for those euros through HSBC to third party.

It is interesting to understand how the large institutions manage the large sums of money that back insurance policies and currency exposures.

There is another forward looking contract which is used by the financial institutions and individual investors alike. These are "Futures" contracts.

Futures contracts are used for hedging to risk, but they are also bought or sold by speculators. There are instances where futures are used instead of an underlying security or index of stocks because of they are less expensive than the underlying security and the trading is more efficient.

Next week's edition will focus on what the Futures Hold.

Patrice Horner holds an MBA in Finance, a FINRA Series 7 Licence, and is a Certified Financial Planner (CFP-US). Any opinions expressed in this article are not specific recommendations, nor endorsements of any productions. Individuals should consult with their banker, insurance agent, lawyer, accountant, or a financial planner for advice to address their personal situations.