Forwards and Futures

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.

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