Explain what forwards, futures and swaps are
The idea
Forward commitments oblige both parties to transact at terms agreed today. A forward is a customised, over-the-counter agreement to buy or sell an asset at a set price on a set date, carrying counterparty credit risk. Futures are the exchange-traded, standardised version: a clearing house stands between the parties and positions are marked to market daily, which largely removes credit risk. A swap exchanges series of cash flows over time and can be viewed as a bundle of forward contracts.
Formulas
Forward payoff at expiry
L = S − F and H = F − S
- L
- the gain or loss to the buyer of the forward
- H
- the gain or loss to the seller
- S
- the price of the underlying at expiry
- F
- the price fixed at the start
The two sides always sum to zero: one party's gain is the other's loss.
A practice question
A forward commitment obliges:
- neither party, until settlement dateWhy not: The obligation is created at agreement; settlement is when it is performed, not when it arises.
- both parties to transact on the agreed terms - correct
- only the buyer, who may choose to walk awayWhy not: That describes an option, where one side pays for the right to decline. A forward commitment binds both.
A forward commitment is a promise made today to trade at a set price later. The key idea is that the promise binds both sides from the moment it is agreed. The actual trade happens on the settlement date, but the duty to carry it out exists from day one. This is what separates it from an option, where only the buyer has a choice and may walk away.
A harder one
A plain vanilla interest rate swap is most accurately described as:
- a series of forward contracts - correct
- a single option on a bondWhy not: No optionality is present; both legs must be paid whatever rates do.
- an equity claim on the counterpartyWhy not: A swap creates no ownership interest, only a series of payment obligations.
A plain vanilla swap is the simplest kind: one side pays a fixed interest rate and the other pays a floating one, and they swap the difference on set dates. Each of those dates is like a separate forward deal, fixing today the rate you will pay or receive then. So the swap is best seen as a series of forward contracts bundled and priced together. It has no option feature and gives no ownership stake.
The hardest tier
A corporate treasurer needs to hedge an exposure of an unusual size on a non-standard date. They would most likely use:
- an exchange-traded futures contractWhy not: Standardised in size and date, which is exactly what this exposure does not match.
- a listed optionWhy not: Also standardised, and it supplies a right rather than the fixed hedge described.
- a forward contract - correct
To hedge means to lock in a price so that a future price move cannot hurt you. Exchange-traded futures come in fixed sizes and fixed dates. If your exposure has an odd size and a non-standard date, a futures hedge would not line up exactly, and the leftover mismatch is called basis risk. A forward is a private contract, so it can be written for exactly your size and date. That is why a forward fits best.
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