CFA Level I Derivatives - Forward Contracts vs Futures Contracts

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 watching an excerpt from our comprehensive and animation library for more videos like these head on down to prep Nuggets comm earth prep Nuggets let us do the hard work for you

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Keywords: CFA Level 1, CFA Level I, Derivatives, CFA Prep Course, CFA Prep Provider, CFA Lesson, CFA Tutorial, CFA Video

Id: 423QLJo2-Jo

Length: 8min 24sec (504 seconds)

Published: Mon Jan 13 2020