long hopes the price of the underlying will rise above the forward price, F0(T ), whereas the short hopes the price of the underlying will fall below the forward price. Except in the extremely rare event that the underlying price at T equals the forward price, there will ultimately be a winner and a loser.
An important element of forward contracts is that no money changes hands between parties when the contract is initiated. Unlike in the purchase and sale of an asset, there is no value exchanged at the start. The buyer does not pay the seller some money and obtain something. In fact, forward contracts have zero value at the start. They are neither assets nor liabilities. As you will learn in later readings, their values will deviate from zero later as prices move. Forward contracts will almost always have non-zero values at expiration.
As noted previously, the primary purpose of derivatives is for risk management. Although the uses of forward contracts are covered in depth later in the curriculum, there are a few things to note here about the purposes of forward contracts. It should be apparent that locking in the future buying or selling price of an underlying asset can be extremely attractive for some parties. For example, an airline anticipating the purchase of jet fuel at a later date can enter into a forward contract to buy the fuel at a price agreed upon when the contract is initiated. In so doing, the airline has hedged its cost of fuel. Thus, forward contracts can be structured to create a perfect hedge, providing an assurance that the underlying asset can be bought or sold at a price known when the contract is initiated. Likewise, speculators, who ultimately assume the risk laid off by hedgers, can make bets on the direction of the underlying asset without having to invest the money to purchase the asset itself.
Finally, forward contracts need not specifically settle by delivery of the underlying asset. They can settle by an exchange of cash. These contracts – called non-deliverable forwards (NDFs), cash-settled forwards, or contracts for differences– have the same economic effect as do their delivery-based counterparts. For example, for a physical delivery contract, if the long pays F0(T) and receives an asset worth ST, the contract is worth ST – F0(T) to the long at expiration. A non-deliverable forward contract would have the short simply pay cash to the long in the amount of ST – F0(T ). The long would not take possession of the underlying asset, but if he wanted the asset, he could purchase it in the market for its current price of ST. Because he received a cash settlement in the amount of ST – F0(T ), in buying the asset the long would have to pay out only ST – [ST – F0(T )], which equals F0(T ). Thus, the long could acquire the asset, effectively paying F0(T ), exactly as the contract promised. Transaction costs do make cash settlement different from physical delivery, but this point is relatively minor and can be disregarded for our purposes here.
As previously mentioned, forward contracts are OTC contracts. There is no formal forward contract exchange. Nonetheless, there are exchange-traded variants of forward contracts, which are called futures contracts or just futures.
Futures contracts are specialized versions of forward contracts that have been standardized and that trade on a futures exchange. By standardizing these contracts and creating an organized market with rules, regulations, and a central clearing facility, the futures markets offer an element of liquidity and protection against loss by default.
Formally, a futures contract is defined as follows:
A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.
First, let us review what standardization means. Recall that in forward contracts, the parties customize the contract by specifying the underlying asset, the time to expiration, the delivery and settlement conditions, and the quantity of the underlying, all according to whatever terms they agree on. These contracts are not traded on an exchange. As noted, the regulation of OTC derivatives markets is increasing, but these contracts are not subject to the traditionally high degree of regulation that applies to securities and futures markets. Futures contracts first require the existence of a futures exchange, a legally recognized entity that provides a market for trading these contracts. Futures exchanges are highly regulated at the national level in all countries. These exchanges specify that only certain contracts are authorized for trading. These contracts have specific underlying assets, times to expiration, delivery and settlement conditions, and quantities. The exchange offers a facility in the form of a physical location and/or an electronic system as well as liquidity provided by authorized market makers.
Probably the most important distinctive characteristic of futures contracts is the daily settlement of gains and losses and the associated credit guarantee provided by the exchange through its clearinghouse. When a party buys a futures contract, it commits to purchase the underlying asset at a later date and at a price agreed upon when the contract is initiated. The counterparty (the seller) makes the opposite commitment, an agreement to sell the underlying asset at a later date and at a price agreed upon when the contract is initiated. The agreed-upon price is called the futures price. Identical contracts trade on an ongoing basis at different prices, reflecting the passage of time and the arrival of new information to the market. Thus, as the futures price changes, the parties make and lose money. Rising (falling) prices, of course, benefit (hurt) the long and hurt (benefit) the short. At the end of each day, the clearinghouse engages in a practice called mark to market, also known as the daily settlement. The clearinghouse determines an average of the final futures trades of the day and designates that price as the settlement price. All contracts are then said to be marked to the settlement price. For example, if the long purchases the contract during the day at a futures price of £120 and the settlement price at the end of the day is £122, the long’s account would be marked for a gain of £2. In other words, the long has made a profit of £2 and that amount is credited to his account, with the money coming from the account of the short, who has lost £2. Naturally, if the futures price decreases, the long loses money and is charged with that loss, and the money is transferred to the account of the short.7
The account is specifically referred to as a margin account. Of course, in equity markets, margin accounts are commonly used, but there are significant differences between futures margin accounts and equity margin accounts. Equity margin accounts involve the extension of credit. An investor deposits part of the cost of the stock and borrows the remainder at a rate of interest. With futures margin accounts, both parties deposit a required minimum sum of money, but the remainder of the price is not borrowed. This required margin is typically less than 10 % of the futures price, which is considerably less than in equity margin trading. In the example above, let us assume that the required margin is £10, which is referred to as the initial margin. Both the long and the short put that amount into their respective margin accounts. This money is deposited there to support the trade, not as a form of equity, with the remaining amount borrowed. There is no formal loan created as in equity markets. A futures margin is more of a performance bond or good faith deposit, terms that were previously mentioned. It is simply an amount of money put into an account that covers possible future losses.
Associated with each initial margin is another figure called the maintenance margin. The maintenance margin is the amount of money that each participant must maintain in the account after the trade is initiated, and it is always significantly lower than the initial margin. Let us assume that the maintenance margin in this example is £6. If the buyer’s account is marked to market with a credit of
The actual amount of money charged and credited depends on the contract size and the number of contracts. A price of £120 might actually refer to a contract that has a standard size of £100,000. Thus, £120 might actually mean 120 % of the standard size, or £120,000. In addition, the parties are likely to hold more than one contract. Hence, the gain of £2 referred to in the text might really mean £2,000 (122 % minus 120 % times the £100,000 standard size) times the number of contracts held by the party.
