Contrast futures with forwards on cash flows and counterparty credit risk
The idea
A forward settles once, at expiry, so the whole gain or loss accumulates as an unrealised claim on a single counterparty. A future is marked to market daily through an exchange: the same economic exposure is delivered, but the profit or loss is settled in cash every day and credit exposure never accumulates beyond one day's move. The daily settlement changes the timing of cash flows, which matters when interest rates are correlated with the underlying, and it forces a margin account that must be topped up on demand.
A practice question
What is the principal operational difference between a forward and a future?
- A forward is cash settled while a future is physically settledWhy not: Either contract can settle by cash or by delivery, so this is not the defining difference.
- A future has its gains and losses settled in cash every day - correct
- A future is written on commodities, a forward on financial assetsWhy not: Both contracts exist on both kinds of underlying, so the underlying does not separate them.
A forward is settled once, on the final day. A futures contract is settled every day: at each day's close, gains and losses are paid in cash, which is called marking to market. Example: you hold a long futures contract on 100 units and the price rises by 2 today. Gain = 100 × 2 = 200, and this 200 is added to your margin account (a cash deposit that backs your position) the same day. With a forward, that 200 would stay unpaid until expiry.
A harder one
Why does a futures position carry less counterparty credit exposure than an otherwise identical forward?
- Because futures are always fully collateralised in advanceWhy not: Initial margin is a fraction of the notional, not full collateral. What limits exposure is settling each day.
- Because futures have shorter maturities than forwardsWhy not: Futures can have long maturities, and maturity is not what limits credit exposure. Daily settlement does.
- Because gains and losses are settled daily - correct
Credit exposure is how much the other side owes you if it fails to pay. With a forward, your gain builds up unpaid for the whole life of the contract, so you rely on one counterparty to pay at the end. With futures, gains are paid into your margin account every day (marking to market), so only one day's move is ever at risk. A clearing house also stands between buyer and seller. Example: a forward gaining 30,000 over six months leaves 30,000 owed at the end. The same gain on a future would already have been paid in daily instalments.
The hardest tier
When can daily settlement make a futures price differ from the forward price on the same underlying and expiry?
- When the underlying is a commodityWhy not: Storage costs and convenience yield affect both prices alike, so they do not create a gap between them.
- When interest rates are correlated with the underlying - correct
- When the contract runs for longer than a yearWhy not: Maturity lengthens the effect but does not create it; correlation with rates is what does.
With futures, gains and losses are paid every day, and that cash is then invested or borrowed at the current interest rate. If interest rates have no link to the underlying's price, these effects balance out and the futures price equals the forward price. If rates tend to rise when the underlying rises (positive correlation), gains are invested at higher rates and losses funded at lower ones. That makes the futures more valuable, so Futures price > Forward price. With negative correlation it is the other way round.
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