DERIVATIVES R US/V1N15/Forward Contracts and Futures Contracts
VOLUME 1, NUMBER 15/June 12, 1995
Most of the readers of misc.invest.futures are participants or at least followers of futures markets. In order to understand futures contracts, however, it is important that one first understand forward contracts. There is a distinction that can be quite significant. Ten years ago, forward markets hardly mattered unless you traded currencies. Now forward markets are becoming much more active. Yet there is so little you hear about them.
First off, let's define a forward contract. It is an agreement between two parties in which they agree that on a future date, one party (the buyer) will pay the other party (the seller) a sum of money and will receive something in return. That "something" could be an asset, a currency, an option or just another sum of money representing the value of an asset or currency. This definition sounds remarkably like that of a futures contract. However, there are several differences.
The parties to a forward contract reach their agreement without the involvement of a futures exchange and clearinghouse. This means that they are not trading the types of standardized contracts available on the futures exchange. If they agree that their contract for gold terminates on September 10, so be it. COMEX does not offer a gold contract expiring in September and if it did, the expiration would probably not be the tenth. Likewise the parties could agree that their contract covered 77,550 ounces, a volume not obtainable with whole COMEX contracts.
More importantly, however, each must agree to assume the credit risk of the other party. Depending on their own perceptions of the credit risk, they might impose some type of collateral requirements but they are very unlikely to require margins or daily settlements of the kind required on the futures exchanges.
When first established, a forward contract is neither an asset nor a liability. It is simply an agreement. Neither party pays anything to the other. This means that its value at the onset is zero.
Once established, forward contracts are not generally designed to be tradable in the market. That is, there is essentially no secondary market. However, let's say I go long one September gold forward contract at a price of 391. Now, let's say it is August 1 and that new contracts that would require delivery on the same date as my existing contract are going for 393. I could go short a new contract and I would have locked in the purchase of the gold in September at 391 and its sale at 393. This guarantees a profit of 2, which has some discounted value of slightly less than 2. Thus, my forward contract now has a value of the present value of 2. I could then view it as an asset, but a later drop in price could turn it into a liability.
Forward prices are obtained by taking the spot price and adding to it the cost of carry, which is the storage cost and the interest foregone minus any convenience yield or dividend/interest paid on the underlying. If this sounds like the way you price futures, indeed it is. However, this rule ignores two major considerations that can lead to price differentials between forwards and futures.
The first is that your futures contract will be marked to market daily whereas your forward contract will not. Will this cause forward prices to deviate from futures prices? It certainly can. However, if the future course of daily interest rates is known, it is possible to set up a risk-free arbitrage between forward and futures contracts that will profit if there is any deviation in forward and futures prices. Thus, forward prices would have to equal futures prices.
But suppose the course of future interest rates is not known. Then such a risk-free arbitrage transaction is not profitable. We can gain some insights into how forward and futures prices will differ by considering a situation in which a party who can trade either a forward or a futures contract is bullish on the underlying commodity. Would he prefer a forward or a futures contract? Suppose interest rates are positively correlated with futures prices. Then he would prefer futures because he will profit when interest rates are rising, allowing him to earn higher returns on the reinvestment of his daily mark to market profits. Likewise, he'll lose on his futures position while interest rates are falling, which mitigates some of the loss.
Thus, when futures prices and interest rates are positively correlated, futures will be preferred over forwards and will carry higher prices. There are a few other related conditions that can lead to equivalent or different futures and forward prices but we won't get into them here.
Another very important consideration, however, is the aforementioned credit risk issue. There is no clear consensus on just how much of a differential might exist due to the credit risk present on forwards that is not present on futures. That would depend on the relative credit qualities of the two parties and whether the stronger party is going long or short. However, credit is clearly a consideration.
All that having been said and done, are there significant differences in real futures and forward prices. The research on this subject says that the differences are very small but that doesn't mean one can always ignore them. Trading futures offers many advantages over trading forwards but the forward market is huge and, therefore, offers many advantages itself to parties large enough to participate.
Why does this matter to futures traders? Because these markets are intertwined in a complex but nearly invisible web. Dealer firms, particularly those in such highly active markets as Eurodollars, are laying off risk in forward, futures, options and swap markets. Awareness of the characteristics of forward markets is as important for futures traders as is awareness of the underlying cash market.
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