FRM Exam Part I · Commodity Forwards and Futures

Commodity Forwards and Futures Basics for FRM Part I

Updated 11 October 2026 · Fact-checked

A commodity forward is a private contract to buy or sell a physical commodity at a fixed price on a future date. A commodity future is the same promise, standardized and traded on an exchange with daily margining. To solve questions, identify the position, compute the payoff as spot minus agreed price, then check delivery and settlement terms.

Understand Commodity Forward and Futures Basics

A commodity forward is an agreement made today to buy or sell a set quantity of a commodity, such as crude oil, wheat or copper, at a fixed price (the delivery price) on a set future date. No one pays the full price today. The buyer is long. The seller is short.

A commodity futures contract has the same economics, but it is standardized and traded on an exchange. The exchange fixes the quantity, quality grade, delivery location and delivery months. A clearinghouse stands between buyer and seller. Positions are marked to market daily, and both sides post margin. This removes most counterparty risk.

Forwards are OTC and customized. You can choose the exact quantity, grade and date. The cost is counterparty (credit) risk, because settlement happens only at maturity, and you cannot easily exit before then. Futures give liquidity and low credit risk, but the standard terms may not match your exact exposure. That mismatch is basis risk.

Hedgers use these contracts to lock in prices. A producer such as a gold miner or oil company sells forwards or futures. A consumer such as an airline or a food manufacturer buys them. Speculators take positions to profit from price moves and supply liquidity. Arbitrageurs exploit gaps between futures and spot prices.

Commodities differ from financial assets. They have storage costs, may be perishable, can have seasonal supply, and offer a convenience yield to those holding the physical good. Delivery is physical in many contracts (crude oil, grains), so the contract defines grade and location. Some contracts are cash settled against an index price. In practice, most futures positions are closed out before delivery by taking the opposite trade. Financial futures, such as stock index futures, are often cash settled and have no storage issue.

Key formulas to remember

Payoff of long forward or futures at maturity: Payoff (long) = S_T − K; S_T is the spot price at maturity and K is the delivery price (or futures price when the position was opened). Multiply by contract size and number of contracts.
Payoff of short position: Payoff (short) = K − S_T; The short's gain is the long's loss. The two sides sum to zero.
Futures daily gain or loss: Daily P&L (long) = (F_t − F_t−1) × contract size × number of contracts; Short position has the opposite sign. Cash moves through the margin account each day.
Hedged price for a short hedger: Effective price ≈ S_T + (F_0 − F_T) = F_0 + Basis_T; Basis_T = S_T − F_T. If basis is zero at close-out, the hedger locks in F_0.
Basis: Basis = Spot price − Futures price; Use the question's convention. Some texts define basis the other way, so read carefully.

How to solve Commodity Forward and Futures Basics questions

Use this method for any question on commodity forward and futures mechanics, uses and differences.

1Identify the instrument: forward (OTC, customized, settled at maturity) or futures (exchange, standardized, daily margined).
2Identify the position: long (buyer) or short (seller), and the user's exposure (producer, consumer, speculator).
3Write down contract size, number of contracts, agreed price K or futures prices, and the final spot price.
4Compute the payoff: long = S_T − K, short = K − S_T, then multiply by size and number of contracts.
5For a hedge, add the gain or loss on the physical position and the derivative position to get the net effective price.
6Check delivery terms: physical or cash settlement, grade, location, and whether the position is likely to be closed before delivery.
7Check the risk named in the question: credit risk (forwards), basis risk (mismatch), or liquidity and margin risk (futures).
8Pick the option that matches your computed result and uses the correct sign and units.

Quickest way: Position, payoff, risk in three checks

When to use it: Use for conceptual MCQs that compare forwards with futures, or ask who benefits from a price move.

Ask: exchange or OTC? Exchange means standardized, daily margin, low credit risk. OTC means customized, higher credit risk.
Ask: does the user own or need the commodity? Owner or producer is naturally long physical, so hedge by selling. Consumer is short physical, so hedge by buying.
Ask: price up or down? Long gains if spot rises above K. Short gains if it falls.
Eliminate options that claim futures have no basis risk or that forwards are marked to market daily.

Common mistakes in Commodity Forward and Futures Basics

Saying forwards and futures have identical cash flows.
The payoff at maturity looks the same, so students ignore timing.
Fix: Futures settle daily through margin. Forwards typically settle once at maturity. This also creates counterparty risk for forwards.
Reversing the hedge direction.
Students think a producer fears a price rise.
Fix: A producer fears a price fall and sells (shorts). A consumer fears a price rise and buys (goes long).
Assuming most futures end in physical delivery.
The contract specification mentions delivery, so students overstate it.
Fix: Most futures are closed out before delivery by an offsetting trade. Delivery is available, and it keeps futures prices tied to spot, but it is used by a small share of positions.
Treating futures as free of risk because of the clearinghouse.
Low credit risk is confused with no risk.
Fix: Futures still carry market risk, basis risk and funding (margin call) liquidity risk.
Getting the sign of basis wrong.
Different textbooks define basis differently.
Fix: Use the definition in the question. In the standard FRM convention, basis = spot − futures.
Ignoring contract size and number of contracts.
Students stop at the per-unit price change.
Fix: Multiply the per-unit gain by contract size, such as 1,000 barrels, and by number of contracts.

Worked examples

Example 1

An airline buys 10 crude oil futures contracts at USD 80 per barrel to hedge fuel costs. Each contract covers 1,000 barrels. At maturity the spot and futures price converge to USD 88. What is the gain or loss on the futures position, and what is the airline's effective purchase price per barrel if it buys the oil at spot USD 88?

Show the solution

The airline is long futures, so the payoff per barrel = S_T − K = 88 − 80 = USD 8.
Total barrels = 10 × 1,000 = 10,000.
Futures gain = 8 × 10,000 = USD 80,000.
The airline pays 88 per barrel in the spot market for the oil.
Effective price = 88 − 8 = USD 80 per barrel.

Answer: Gain of USD 80,000 on futures; effective price USD 80 per barrel.

Example 2

A wheat farmer expects to sell 50,000 bushels in three months. She sells ten 5,000-bushel futures contracts at USD 6.00 per bushel. When she closes out, spot is USD 5.70 and futures is USD 5.80. What is her effective selling price per bushel?

Show the solution

She is short futures, so the gain per bushel = F_0 − F_T = 6.00 − 5.80 = USD 0.20.
She sells the wheat at spot, receiving USD 5.70.
Effective price = 5.70 + 0.20 = USD 5.90.
Check with basis: basis at close = S_T − F_T = 5.70 − 5.80 = −0.10.
Effective price = F_0 + basis = 6.00 − 0.10 = USD 5.90.
Total proceeds = 5.90 × 50,000 = USD 2,95,000 in plain terms, i.e. USD 295,000.

Answer: Effective price is USD 5.90 per bushel, a total of USD 295,000. It is below USD 6.00 because the basis was −0.10 at close-out.

Exam tips

Expect conceptual comparisons: forward versus futures on credit risk, liquidity, customization and settlement. Know the table by heart.
Always attach a sign to the payoff. Check whether the question asks about the long or the short.
In hedging questions, compute the effective price as spot plus futures gain (short) or spot minus futures gain (long). Verify with the basis shortcut.
Watch the units: barrels, bushels, ounces, metric tons. Contract size changes the answer by orders of magnitude.
Remember that commodity-specific features (storage, convenience yield, delivery grade and location) separate commodity contracts from financial ones.

Practice questions from Commodity Forwards and Futures

Commodity Forward and Futures Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Commodity Forward and Futures Basics: frequently asked questions

What is the main difference between a commodity forward and a commodity futures contract?

A forward is a customized OTC agreement, usually settled once at maturity, with counterparty credit risk. A futures contract is standardized, exchange-traded, cleared and marked to market daily. Margin reduces credit risk but can create liquidity strain.

Do commodity futures always end in physical delivery?

No. Many contracts allow physical delivery, but most traders close positions early with an offsetting trade. Some contracts are cash settled against a reference price.

Who uses commodity futures?

Hedgers such as producers and consumers use them to lock in prices. Speculators take price views and add liquidity. Arbitrageurs trade price gaps between futures and spot or between contracts.

Why do commodity contracts have basis risk?

The standard futures grade, location or date may differ from the exposure you hold. So spot and futures prices do not move perfectly together, and the hedge locks in the price only approximately.