CFA Level I Derivatives - Forward Contracts vs Futures Contracts

Summary

This script explains financial derivatives, focusing on forward commitments and contingent claims. Forwards, futures, and swaps are forward commitments where parties agree to future transactions at a set price. Options and credit derivatives are contingent claims, only paying out under specific conditions. The script details forward contracts, their settlement methods, and the difference between over-the-counter forwards and exchange-traded futures. It also discusses the role of the Clearing House in futures, reducing counterparty risk, and the concepts of open interest, settlement price, and margin.

Takeaways

• 📝 A forward commitment is a contract where parties agree to perform an action at a future date.
• 💡 A contingent claim is a contract where a payoff is only claimable if a specific event occurs before contract expiry.
• 📈 Forwards, futures, and swaps are categorized as forward commitment contracts, differing from options and credit derivatives, which are contingent claim contracts.
• 🔄 At the start of a forward contract, a party agrees to buy an asset at a future date at a predetermined price, known as the forward price.
• 💼 The forward price is based on the current market price (spot price) adjusted by the cost of carry.
• 📉 If the spot price rises above the contract price, the long position gains value; if it falls, the short position gains value.
• 💵 In cash-settled forwards, the difference between the contract and spot price is paid out on the settlement date.
• 📦 Deliverable forwards require the short to deliver the asset and the long to pay the contract price, irrespective of the spot price.
• 🏦 Forward contracts are over-the-counter, exposing both parties to credit risk due to potential defaults.
• 🌐 Futures are exchange-traded contracts managed by a Clearing House, which reduces counterparty risk by acting as the counterparty.
• 💼 Futures contracts involve terms like open interest, settlement price, and margin, which are not applicable to forward contracts.

Q & A

What is a forward commitment contract?

A forward commitment contract is a contract where the parties agree to perform some action at a specified future date.

How is a contingent claim different from a forward commitment?

A contingent claim has a payoff that is only claimable if a particular event occurs before the contract expires, unlike forward commitments which are obligated to be fulfilled regardless of external events.

What is the difference between the forward price and the spot price?

The forward price is the agreed-upon price for an asset in a forward contract, set at the initiation of the contract. The spot price is the current market price of the asset.

What happens if the spot price rises above the contract price in a forward contract?

If the spot price rises above the contract price, the long position has a positive value, meaning they would profit from the contract, while the short position has an equal negative value.

How does the settlement process work in a cash settled forward contract?

In a cash settled forward contract, the difference between the contract price and the spot price is calculated at settlement. If the spot price is higher, the short pays the long the difference; if lower, the long pays the short.

What is the role of the Clearing House in futures contracts?

The Clearing House acts as the counterparty to every participant in futures contracts, ensuring that all parties honor their obligations by enforcing rules like margins.

Why are futures contracts considered to have less counterparty risk compared to forward contracts?

Futures contracts have less counterparty risk because the Clearing House guarantees the fulfillment of contracts, removing the reliance on the creditworthiness of the individual parties.

What is the purpose of open interest in futures markets?

Open interest represents the total number of outstanding contracts held by market participants and is used as a measure of the flow of money into the futures market. It can also provide trading signals for speculators.

How is the settlement price of a futures contract determined?

The settlement price is an average of the prices of the trades during the closing period, which helps to reduce the opportunity for manipulation and ensures a fair reflection of the market's closing value.

What is the function of margins in futures contracts?

Margins serve as a financial guarantee for the performance of contracts in futures trading. The initial margin is a deposit required at the start, and the maintenance margin is the minimum amount that must be maintained to cover potential losses.

How does the marking to market process work in futures contracts?

Marking to market is the daily process of adjusting a trader's margin account to reflect gains or losses based on the day's settlement price, ensuring that the account remains adequately collateralized.

Outlines

00:00

📈 Forward Commitments and Contingent Claims

This paragraph introduces two types of derivative contracts: forward commitments and contingent claims. Forward commitments, such as forwards, futures, and swaps, require parties to perform an action at a specified future time. An example is a forward contract where one party agrees to buy an asset from another at a future date for a predetermined price, known as the forward price. This price is typically the spot price adjusted for carrying costs. The contract's value can fluctuate based on the spot price's movement relative to the contract price. Settlement can be cash-settled, where the difference between contract and spot prices is paid, or deliverable, where the asset is exchanged at the contract price. The paragraph contrasts these with contingent claims like options and credit derivatives, which only pay out under certain conditions. It also discusses the risks and characteristics of over-the-counter forward contracts versus exchange-traded futures, which are standardized and involve a clearinghouse to mitigate counterparty risk.

05:02

💼 Futures Trading: Open Interest, Settlement Price, and Margin

Paragraph 2 delves into specific terms related to futures trading: open interest, settlement price, and margin. Open interest represents the number of outstanding contracts held by market participants and is seen as an indicator of market activity. It increases with new positions and decreases when positions are closed. Settlement price is the average of the closing period's trades, not the last trade's price, which helps prevent manipulation. This price is crucial for calculating daily gains or losses and, on the final trading day, equals the asset's spot price. Margin is a deposit required for futures contracts to ensure obligations are met. It includes an initial margin and a maintenance margin, with the former being a low percentage of the contract's value. Daily price changes lead to gains or losses that are adjusted against the margin account through a process called marking to market. If the account falls below the maintenance margin, additional funds are needed. The paragraph concludes by encouraging viewers to visit a website for more educational content.

Keywords

💡Forward Commitment

A forward commitment is a type of contract where parties agree to perform an action at a future date. In the context of the video, forward commitments include derivatives like forwards, futures, and swaps where the obligation to buy or sell an asset is set at the initiation of the contract. For example, a forward contract is initiated with a forward price, which is agreed upon by the parties involved.

💡Contingent Claim

A contingent claim is a type of financial instrument where the payoff is dependent on the occurrence of a specific event before the contract expires. Options and credit derivatives are mentioned as examples of contingent claims in the script, where the value is only realized if certain conditions are met.

💡Settlement Date

The settlement date is the future point in time at which the transaction agreed upon in a forward contract is completed. The script explains that in a forward contract, one party agrees to buy an asset from another at a specified price on this future date.

💡Forward Price

The forward price is the agreed-upon price at which an asset will be bought or sold in a forward contract on the settlement date. The video script mentions that this price is determined at the initiation of the contract and is based on the current market or spot price, adjusted by the cost of carry.

💡Spot Price

The spot price is the current market price of an asset. It is used as a reference when setting the forward price in a forward contract. The script notes that the forward price is the spot price adjusted for the cost of carry.

💡Long and Short

In the context of derivatives, 'long' refers to the party who agrees to buy the asset, while 'short' refers to the party who agrees to sell. The video script uses these terms to describe the positions taken by parties in a forward contract.

💡Cash Settled Forward Contract

A cash settled forward contract is a type of forward contract where the difference between the contract price and the spot price at settlement date is paid in cash, rather than through the physical delivery of the asset. The script explains this concept by stating that if the spot price is higher than the contract price, the short pays the long the difference.

💡Deliverable Forward

A deliverable forward is a type of forward contract where the underlying asset is actually delivered at the settlement date, and the contract price is paid. This is contrasted with a cash settled forward in the script, where the physical delivery is not required.

💡Credit Risk

Credit risk refers to the risk that one party to a contract will default. The script mentions that in over-the-counter forward contracts, both the long and short are exposed to credit risk as they rely on each other to fulfill the contract terms.

💡Clearing House

A clearing house is an entity that acts as an intermediary between buyers and sellers to ensure that trades are completed. In the context of futures contracts, as explained in the script, the clearing house eliminates counterparty risk by acting as the counterparty to every trade.

💡Open Interest

Open interest refers to the total number of outstanding contracts for a particular futures contract. The script explains that it increases with new positions and decreases when positions are closed, serving as a measure of money flow into the futures market.

💡Settlement Price

The settlement price is the average of the prices of trades during the closing period of a trading day. It is used to calculate daily gains or losses and is mentioned in the script as a mechanism to reduce the chance of price manipulation.

💡Margin

Margin is an initial deposit required in futures contracts to ensure that parties can fulfill their obligations. The script describes initial margin as a relatively low deposit compared to the contract size, which is subject to a 'marking to market' process and maintenance margin requirements.

Highlights

A forward commitment is a contract where parties agree to perform an action at a given time.

A contingent claim is a contract with a payoff only claimable if a specific event occurs before contract expiry.

Forwards, futures, and swaps are forward commitment contracts, while options and credit derivatives are contingent claim contracts.

In a forward contract, one party agrees to buy an asset from another at a specified future date at a predetermined price.

The forward price is based on the current market price, adjusted by the cost of carry of the asset.

The contract price is locked in once the forward contract is initiated.

If the spot price rises above the contract price, the long has a positive value and the short has an equal negative value.

If the spot price falls below the contract price, the short has a positive value and the long has an equal negative value.

In a cash settled forward contract, the difference between the contract price and spot price is paid by one party to the other.

In a deliverable forward, the short delivers the asset to the long at the contract price, regardless of the spot price.

Forwards are over-the-counter contracts with credit risk exposure for both parties.

Futures are exchange-traded contracts with the Clearing House acting as the counterparty, reducing counterparty risk.

The Clearing House enforces rules like margins to ensure traders honor their obligations.

Futures contracts are standardized and regulated, unlike forwards which are usually non-standard and unregulated.

Open interest in futures is the total number of outstanding contracts held by market participants at the end of the day.

Settlement price in futures is an average of the closing period prices, not the final trade price.

Margins in futures contracts are initial deposits required by the Clearing House to guarantee obligations.

Marking to market is the process of adjusting a margin account daily based on gains or losses from futures price changes.

Maintenance margin is the minimum amount that must be maintained in a margin account for futures contracts.

Hedges can use futures contracts to reduce risk exposure to changes in asset prices.

Companies can use futures to hedge against future increases in commodity prices, like oil.

Futures provide liquidity, making them attractive to speculators and hedgers.

Transcripts

a forward commitment is a contract where

the parties are required to perform some

action at a given time a contingent

claim consists of a payoff which is only

claimable if a particular event happens

before the expiry of the contract we

should go into an introduction of each

of these classes of derivatives which

will explain why forwards futures and

swaps are forward commitment contracts

while options and credit derivatives are

contingent claim contracts at the

initiation of a forward contract one

party agrees to buy an asset from

another party not today but on a

specified settlement date in the future

at a specified price this price is known

as the forward price by convention the

party who agrees to buy is called for

long while the party who agrees to sell

is called a short neither party makes a

payment at this point the forward price

is based on the current market price of

the asset also known as the spot price

adjusted by the cost of carry of the

asset we shall learn more about the

pricing mechanism in a future lesson so

we'll leave it as that for now once the

contract is initiated it becomes locked

in as the contract price

over the life of the contract if the

spot price rises such that the expected

future price is above the contract price

the long will have a positive value

while the short will have an equal

negative value the opposite is true if

the spot price goes down such that the

expected future price is below the

contract price the short will have a

positive value while the long will have

an equal negative value what happens on

the settlement date depends on what is

specified in the forward contract in a

cash settled forward contract the

difference between the contract price

and spot price is calculated if the spot

price is higher than the contract price

the short has to pay the long the

difference conversely if the spot price

is lower the long has to pay the short

the difference cash settled forward

contracts are also known as contracts

for differences or non deliverable

forwards another form of settlement is

known as a deliverable forward in this

case the short is required to deliver

the underlying asset to the long and the

long pays for it at the settlement price

note that the price paid for the asset

is the contract price not the spot price

the spot price has no bearing in this

arrangement so if the spot price is

lower than the contract price at

settlement 8 as in this case the long is

disadvantaged because it is paying a

higher price than the market price for

the asset as mentioned earlier forwards

are over-the-counter contracts in which

the agreement is between the long and

the short as such both parties are

exposed to credit risk as either party

has the potential to default from the

agreement as the contracts are

negotiated they are usually non-standard

to fit the requirements of both parties

forward contracts also tend to be

unregulated in contrast futures are

exchange-traded contracts in which the

agreement is with the Clearing House the

Clearing House does this by splitting

each trade acting as the opposite side

of each position it acts as the buyer to

every seller and the seller to every

buyer this system allows either side of

the trader of

positions at a future date without

having to contact the other side of the

initial trade traders will be able to

reverse or reduce their position with

ease the Clearing House also acts as the

counterparty for each participant the

Clearing House enforces rules like

margins which we'll discuss later on the

participants this allows the Clearing

House to guarantee that traders in the

exchange will honor their obligations

this guarantee removes counterparty risk

from futures contracts in the history of

u.s. Futures Trading the Clearing House

has never defaulted on a contract to

facilitate trading futures are standard

contracts where traders either take the

long or short position with standard

sizes futures markets are usually

regulated by the government the fluidity

of futures contracts makes them

attractive to speculators who want to

bet on changes in the price of an asset

hedges can also use futures contracts to

reduce their risk exposure to the

changes in price of an asset for example

a transport company can buy oil futures

to hedge against future increases in oil

price if oil prices do increase in the

future the company can sell the oil

futures at a profit which will soften

the increase in operating costs due to

increase in fuel prices if the transport

company wishes to take delivery of the

oil or enter into custom contracts more

suited to its needs the company can turn

to forward contracts instead besides

these differences there are three terms

that apply only to futures they are open

interest settlement price and margin the

open interest of any particular futures

contract is the total number of

outstanding contracts that are held by

market participants at the end of the

day open interest increases when traders

enter new long and short positions and

decreases when traders exit existing

positions open interest is therefore a

measure of the flow of money into the

futures market some speculators look for

trading signals based on the open

interest for a particular asset

settlement price is analogous to the

closing price for a stock but it's not

simply the price of the final trade of

the day it's an average of the prices of

the trades during the last period of

trading called the closing period so as

in this case even though the final trade

of the day was done at $88 the

settlement price is recorded at the

average price of the closing period

which is $76 this specification of a

settlement price reduces the opportunity

of traders to manipulate the settlement

price the settlement price is used to

calculate the daily gain or loss at the

end of each trading day on its final day

of trading the settlement price is equal

to the spot price of the underlying

asset margin applies to futures

contracts but not forward contracts

recall that under a futures contract

Clearing House is able to guarantee that

all parties will honor their obligations

this is achieved through requiring both

the long and the short to place an

initial deposit known as the initial

margin the initial margin per contract

is relatively low as compared to the

size of the contract for example if a

trader longs the futures at $100 at this

point an initial margin of $20 may be

imposed by the Clearing House this

initial margin is deposited in the

traders margin account after the futures

contract is obtained changes in the

price of the futures contract result in

daily gains or losses they're credited

to or subtracted from the margin account

of the contract holder this is called

the marking to market process the

maintenance margin is the minimum amount

of margin that must be maintained in the

margin account if the balance in the

account falls below the maintenance

margin additional funds must be

deposited to bring the margin balance

back up to the initial margin amount so

in this case the trader has to top up

his margin account by $24 to bring the

account balance back to $20 note that

this is different from the case of an

equity account which requires investors

only to bring the margin back up to the

maintenance margin amount you're

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