What is it ?
- A forward is an OTC agreement between two parties to buy or sell an asset at a pre-agreed two parties to buy or sell an asset at a pre-agreed price at any pre-agreed future date.
- A futures contract is listed contract, traded on a futures exchange, to buy or sell at a certain date in the future, at a pre-agreed price.
How is it constructed ?
FORWARD: (OTC)
- Margin exchange takes place initially (optional)
- No actual cash/asset exchanged until maturity of the contract, where P/L is realised in cash.
- Forwards are then settled at the forward price agreed on the trade date.
FUTURES: (via exchange)
- Initial margin paid to the exchange and P/L exchanged daily on mark to market.Variation margin may be exchanged on losses/gains.
- Position can be closed out at any time by taking an opposite e.g. short the same future.
- At expiry, either physically settled or cash settled.
- The final settlement price for a future is often a special quotation (EDSP) which may or may not be the same as the closing price that day.
When is it used ?
HISTORICALLY:
- Orginally used by farmers to guarantee a cetain price for their crop (selling futures before harvast).
- Also used by consumers of commodities to fix costs in advance (e.g. livestock farmers buying food futures).
TODAY:
- Used by investors who wish to hedge out the risk of an underlying asset/derivatives through the futures market.
- Used by speculators who seek to make a profit by predicting on paper for which they have no practical use.
What are the benefits ?
- Leveraged exposure: Buyers of futures / forxards do not have to pay the full value of the asset in advance, and can therefore achieve leveraged gains ( at the risk of leveraged losses)
- Forwards contracts can be tailored to suit the exact needs of the client (maturity, underlying), and can also be structured with lower requirement for initial / variation margin
- However, standardized futures contacts are very liquid and often therefore trade for reduced margins.
The Financial Engineer 