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Contrast forward contracts with futures contracts, noting similarities and differences.

FRM® Part I · Financial Markets and Products · Futures Markets · FRM1.FM.7.g

The idea

Forwards and futures both fix a price today for a transaction at a future date, and both can hedge or speculate. A forward is a private over-the-counter contract with customised terms. It is typically held to maturity and settled once, usually by delivery, and it carries counterparty credit risk. A futures contract is standardised, exchange-traded, cleared through a clearing house, margined and settled daily. It is usually closed out before delivery, so credit risk is small, liquidity is high and trading is regulated. Because futures gains and losses are settled daily, the interest earned or paid on them can make the futures price differ slightly from the forward price. The futures price is higher when asset prices are positively correlated with interest rates. Exam point: the final economic result is similar, but cash-flow timing, credit risk and customisation differ.

A practice question

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

Which statement correctly contrasts forward and futures contracts?

  1. Forwards are traded on exchanges and cleared centrally, while futures are private bilateral agreements.Why not: Reverses the market structure.
  2. Both are standardised contracts, but only the forwards are margined and settled daily.Why not: Forwards are customised, and daily margining is a futures feature.
  3. Futures are customised to each user's needs, while forwards are standardised.Why not: Reverses customisation and standardisation.
  4. Forwards are customised OTC agreements; futures are standardised and exchange-traded. - correct

Forwards are bilateral OTC contracts tailored to the parties; futures are standardised exchange-traded contracts cleared by a clearing house.

A harder one

Assume the underlying asset's price is strongly positively correlated with interest rates. How does the futures price compare with the forward price for the same maturity?

  1. The futures price is slightly lower, because losses must be funded when interest rates are high.Why not: Reverses the effect: with positive correlation, long gains arrive when rates are high, which raises the futures price.
  2. They are identical, because the underlying and maturity are the same.Why not: Equality holds only when interest rates are constant or uncorrelated with the underlying.
  3. The futures price is slightly higher, because gains arrive when rates are high and can be reinvested at higher rates. - correct
  4. The difference depends only on the credit quality of the forward counterparty.Why not: Credit quality does not explain this difference; the interest rate correlation does.

With positive correlation, daily gains on a long futures tend to arrive when rates are high, which makes the futures more valuable and pushes its price above the forward.

The hardest tier

A hedger is long 50 futures contracts of 1,000 units, entered at 100. The price falls to 96 and then recovers to 98 at expiry. The same hedger has a long forward on the same 50,000 units at 100. Which statement describes the two hedges?

  1. Peak cumulative variation margin payment of USD 200,000, ending net loss of USD 100,000 (same as the forward's, paid only at maturity). - correct
  2. The futures hedge needs a peak cumulative payment of USD 100,000 and ends with a net loss of USD 100,000 at expiry.Why not: Assumes the interim payments are the same as the final result, missing the larger interim payment at the trough.
  3. The futures hedge needs a peak cumulative payment of USD 200,000 and ends with a net loss of USD 200,000 at expiry.Why not: Treats the peak interim payment as the final loss, ignoring the later recovery.
  4. The futures hedge needs a peak cumulative payment of USD 200,000 and ends with a net loss of USD 300,000 at expiry.Why not: Adds the recovery as a further loss instead of netting it against the payments already made.

Futures: -4 x 50,000 = -200,000 at the trough, then +2 x 50,000 = +100,000, ending at -100,000. The forward loses the same 100,000, but only at maturity, so it has no interim liquidity need.

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