10.6 Forwards And Futures

Overview

Forwards and Futures

A forward is a contractual agreement between two parties: a buyer and a seller. Here, the buyer agrees to purchase an underlying asset from the seller at a predetermined future date for a predetermined price. Unlike options agreements where participation may be optional, both parties in a forward contract are obligated to complete the trade.

Forwards may trade on an exchange or over-the-counter (OTC) market. When a forward contract is traded on an exchange, it is known as a futures contract.

Key Characteristics and Differences

Forwards:

• Customized contracts
• Traded OTC
• Counterparty risk is relatively higher

Futures:

• Standardized contracts
• Traded on exchanges
• Counterparty risk mitigated by clearinghouses

Classification of Futures

Futures are typically classified into two categories based on the types of underlying assets:

1. Financial Futures

These contracts involve financial instruments as the underlying assets. Common types include:

• Stocks
• Bonds
• Currencies
• Interest Rates
• Stock Indexes

2. Commodity Futures

These contracts involve physical commodities as the underlying assets. Common examples include:

• Precious and Base Metals
• Crude Oil and Natural Gas
• Grains and Oilseeds
• Meats and Dairy
• Lumber

Forward Agreements

When a forward contract is traded over the counter, it is generally termed as a forward agreement. The most prevalent types of forward agreements typically involve currencies and interest rates.

Glossary

Forward Contract: A private, customizable agreement to buy or sell an asset at a specified future date for a price determined today.

Futures Contract: A standardized agreement traded on an exchange to buy or sell a specific amount of a commodity or financial instrument at a set price on a certain date in the future.

OTC (Over-the-Counter): A decentralized market where trading is done directly between two parties, without the oversight of an exchange.

Clearinghouse: An intermediary between buyers and sellers of financial instruments, ensuring the trade goes smoothly and mitigating the risk of default. :::

FAQs

Q: What is the primary difference between a forward and a futures contract?

A: The primary difference is that forwards are customized contracts traded OTC, whereas futures are standardized contracts traded on exchanges.

Q: What types of assets can be underlying in financial futures?

A: Common underlying assets in financial futures include stocks, bonds, currencies, interest rates, and stock indexes.

Q: Why are forward agreements typically used in interest rates and currencies?

A: Forwards are preferred for interest rates and currencies as they offer customization suitable for hedging specific financial exposures.

Key Takeaways

Key Takeaways

1. Forward Contracts:

   • Customizable agreements tailored to specific needs.
   • Carry higher counterparty risk compared to futures contracts, which are standardized and traded on exchanges.

2. Futures Contracts:

   • Classified based on their underlying assets into:
     • Financial Futures: Contracts based on financial instruments like interest rates, currencies, or indices.
     • Commodity Futures: Contracts based on physical commodities like oil, grains, or metals.

3. Forward Agreements:

   • Particularly used for managing interest rates and currency risks.
   • Allow flexibility in customization to hedge specific financial risks effectively.

Futures Market Structure

    graph TD;
	    A[Trader] -->|buys contract| E[Exchange]
	    B[Trader] -->|sells contract| E
	    E -->|manages| C[Clearinghouse]
	    C --> D[Settlement]

The diagram above illustrates the structure of a futures market where the exchange trades contracts, and the clearinghouse manages and ensures settlement.

Comparison Table: Forwards vs Futures

In this section

• 10.6.1 Key Terms And Definitions
  Comprehensive guide on key terms and definitions in futures contracts, including concepts of margin requirements, marking to market, and cash-settled futures within the context of the Canadian Securities Course.
• 10.6.2 Futures Trading And Leverage
  Comprehensive guide on Futures Trading and Leverage including margin requirements, leverage effects, and safety considerations in futures trading.
• 10.6.3 Futures Exchange
  This chapter provides a detailed overview of the Montréal Exchange, including the listing of index futures, Government of Canada bonds, bankers’ acceptances, and the 30-day overnight repo rate.
• 10.6.4 Futures Strategies For Investors
  Explore key futures strategies for investors including speculative strategies and risk management techniques. Understand the benefits and risks associated with buying and selling futures.
• 10.6.5 Futures Strategies For Corporations
  Understand how corporations utilize futures to manage risks, gain insights on practical examples, and discern differences and similarities between forward and futures contracts.