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derivatives
14 Apr 2020
Forward and futures contracts share several similar features; however, how they are traded and the resulting cash flows mean forward, and futures contracts with the same underlying asset may trade at a different price.
Exchange-traded vs. OTC
One of the main differences between the two is that the forward contract is an over-the-counter agreement between two parties, i.e., a private transaction. On the other hand, futures contracts trade on a highly regulated exchange, according to standardized features and terms of the contract.
Risk Associated with Trading OTC
The primary risk for these two derivatives is different because of how they trade. The principal risk is counterparty risk for the forward contract, which is the risk that one party will default on the agreement. With a forward contract, the mark-to-market and determination and payment of the net gain occur at contract expiration. In a high-interest rate environment, the time value of money component to the end-of-contract cash flow can be material.
Exchange-traded Futures Contracts
Futures contracts are traded on an exchange, and the exchange acts as the counterparty in the agreement, so there is little to no worry about default risk. Futures contracts also have daily settlements through the daily mark-to-market process. Each day, the parties to the transaction must maintain their margin accounts. This daily cash flow means there isn’t a “lump sum” to exchange at contract expiration. This differing cash flow pattern can produce a pricing difference relative to an equivalent forward contract.
Pricing Differential
If interest rates were constant, futures and forwards would have the same prices. The pricing differential between the two varies with the volatility of interest rates. Practically, the derivatives industry makes virtually no distinction between futures and forward prices.
Question
Which of the following best describes why future and forward prices differ?
A. The forward contract has essentially no counterparty risk since it is a private agreement between two parties, which is why forward contracts are more expensive
B. Futures contracts, since traded on an exchange, have more liquidity, hence why it is cheaper to invest in a futures contract
C. Futures contracts settle daily, which means investors in futures contract must hold a margin account
Solution
The correct answer is C.
Futures contracts settle daily which requires the investor to have a margin account. Since futures settle daily, any increase in value will lead to an increase in the excess margin which can then be reinvested.
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