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.