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Explain how forward contracts and futures contracts differ, and how forward prices relate to spot prices.

FRM® Part I · Financial Markets and Products · Pricing Financial Forwards and Futures · FRM1.FM.10.c

The idea

Forward and futures contracts both fix a price today for buying or selling an asset at a future date. A forward is a private over-the-counter agreement, customized in amount and date, settled once at maturity and exposed to the counterparty's credit risk. A futures contract is standardized, traded on an exchange, guaranteed by a clearinghouse and marked to market daily with margin posted, so gains and losses are paid each day rather than at the end. Most futures are closed out before delivery. The forward price is the delivery price that makes a new contract worth zero today. It relates to spot through the cost of carry. It exceeds spot when financing costs exceed the income the asset pays, lies below spot when income exceeds financing costs, and converges to spot as maturity approaches. The forward price is not a forecast of the future spot price.

A practice question

From the question bank, with the reason each wrong option is wrong.

As the delivery date of a forward contract on a financial asset approaches, the forward price:

  1. converges to the forward price set at initiationWhy not: Confuses the forward price with the fixed delivery price of the existing contract.
  2. converges to the spot price plus the full interest accrued since inceptionWhy not: Treats the cost of carry as persisting at delivery; with no time left it is zero.
  3. converges to the spot price of the asset - correct
  4. remains above spot by the risk-free rateWhy not: Ignores that carry reduces to zero as T approaches zero.

F = S x e^((r - q)T) tends to S as T tends to zero, so forward and spot prices converge.

A harder one

A trader is long 10 futures contracts, each on 50 units. The futures price is 250.0 at inception, and the daily settlement prices over the next three days are 252.5, 251.0 and 254.0. The cumulative amount credited to the margin account after the third day, before any margin calls, is:

  1. USD 200Why not: Computes for one contract rather than all 10 contracts.
  2. USD 1,500Why not: Counts only the third day's change of 3.0 on the position.
  3. USD 2,000 - correct
  4. USD 3,500Why not: Sums the absolute daily changes (2.5 + 1.5 + 3.0) instead of the net of gains and losses.

Daily settlement credits the net change: (254.0 - 250.0) x 50 x 10 = USD 2,000. The intermediate loss on day 2 offsets part of the day 1 gain.

The hardest tier

A corporate treasurer must hedge a USD 40 million receipt on an exact future date, in an instrument for which no standard futures contract matches the amount and date. The strongest reason to prefer a forward over a futures contract is that the forward:

  1. eliminates counterparty credit risk because both parties settle on the same dayWhy not: Overlooks that a bilateral forward leaves each side exposed to the other's default.
  2. is more liquid and can be closed out easily before maturityWhy not: Closing out is easier for exchange-traded futures; forwards are usually held to maturity.
  3. pays out gains each day, giving the hedger early cash flowsWhy not: Daily settlement is a feature of futures, not forwards.
  4. can be customized to the exact amount and date and avoids daily margin cash flows, at the cost of counterparty credit risk - correct

Forwards are customized and settle only at maturity, so there is no margin liquidity drain; the trade-off is bilateral credit risk and lower liquidity.

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