###### Overview

A forward contract is an agreement between two parties to exchange at some fixed future date a given quantity of an asset for a fixed price (the forward price) as defined today. A futures contract has the same general features as a forward contract but is transacted through a futures exchange, has standardised terms and the price is determined at settlement. Transacting through the exchange reduces risk but, through this standardisation, reduces the ability of parties to tailor products to meet specific needs.

Futures contracts are rarely taken to maturity are cash settled and delivery of the underlying rarely occurs. In contrast, forwards are often used as hedging instruments and are more typically physically settled.

## Background

The forward markets can be traced back to the Middle Ages and were originally developed to meet the needs of farmers and merchants who wanted to protect against commodity price and delivery risk. The Chicago Board of Trade listed the first exchange-traded futures contract in 1864 and the combined market for these assets is now worth in excess of \$900Bn. Like swaps and options, they are classed as vanilla derivatives and are widely used throughout all asset classes in hedging, speculation, and arbitrage.

## Differences between Futures and Forwards

Fundamentally, forward and futures contracts have the same function: both types of contracts allow parties to buy or sell a specific asset at a specific time at a given price. However, it is in the precise details that these contracts differ.

First of all, futures contracts are exchange-traded standardised contracts. The terms of a futures contract – including delivery places and dates, volume, technical specifications, and credit procedures – are standardised for each type of contract and participants are restricted to trading only the products the exchange offers.  Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions; the settlement date, notional amount of the contract and settlement form (cash or physical) are entirely up to the two parties.

With futures, risk mitigation measures, such as margining and regular mark-to-market, are automatically required by the exchange. Credit risk is minimised through the posting of an initial margin, typically 5%-15% of the contracts value, by both parties. Furthermore, counter-parties exchange payments of profits or losses on the days they occur. Cash flows are therefore frequent and take place throughout the duration of the contract. As a result of these payments, a futures contract’s market value is effectively reset to zero at the end of each trading day.

Without the involvement of an exchange, participants in forwards incur greater market and credit risk and those who engage in forward transactions assume exposure to the counter-party directly. Furthermore, since there are no cash flows until delivery, the profit or loss on a forward contract is only realised at the time of settlement. However, parties may soften these risks by contractually agreeing to margin calls throughout the duration of the contract should pre-specified conditions occur.

Because futures contracts are quite frequently employed by speculators they are usually closed out prior to maturity and delivery usually never happens. However, should the contract be taken to delivery, the counter-party on a futures contract is chosen randomly by the exchange. In both cases, futures settle at the settlement price fixed on the last trading date of the contract (i.e. at the end).On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset’s price and delivery of the asset or cash settlement will usually take place. In case of physical delivery, the forward contract specifies to whom the delivery should be made. In either cash or delivery, the forward contract is settled at the forward price agreed at the trade date (i.e. at the start).

A relationship exists between the current price of an asset (spot-price), the forward, and the futures price; if the asset is liquidly traded or freely created, rational non-arbitrage pricing dictates that the future/forward price should simply be the spot price plus the cost of risk-less borrowing over the length of the contract. However, the daily cash flows associated with margining can skew futures prices, causing them to diverge from corresponding forward prices. Thus, while the future price will converge to the spot price as settlement approaches, the forward prices need not exhibit this behaviour.

Finally, futures are generally subject to a single regulatory regime in one jurisdiction, while forwards, although usually transacted by regulated firms, are transacted across jurisdictional boundaries and are primarily governed by the contractual relations between the parties.

## Futures Market Strategies

Hedging and speculating are two polar uses of futures markets. A speculator uses a futures contract to profit from movements in futures prices, a hedger to protect against price movement.

Why does a speculator buy a futures contract? Why not buy the underlying asset directly? One reason lies in transaction costs, which are far smaller in futures markets. Another important reason is the leverage that futures trading provides. Futures contacts require the posting of margin that is considerably less than the value of the asset underlying the contract. Therefore, they allow speculators to achieve much greater leverage than is available from direct trading in the commodity.

## The Spot-Futures Parity Theorem

A futures contract can be used to hedge changes in the value of the underlying asset. If the hedge is perfect, meaning that the asset-plus-futures portfolio has no risk, then the hedged position must provide a rate of return equal to the rate on other risk-free investments. Otherwise, there will be arbitrage opportunities that investors will exploit until prices are brought back into line. This result is called the spot-futures parity theorem and gives the normal relationship between spot and future prices. In addition, it holds that the difference between futures and spot price will be larger as the maturity of the contract increases.

Given current spot price,

$S_{0}$, discount rate $(1+r_{f})$, current dividend to be paid until maturity $I$ and T-periods then we conclude that:

$F_{0} = (S_{0}-I)(1+r_{f})^T$

The parity relationship is also called the cost-of-carry relationship because it asserts that the futures price is determined by the relative costs of buying a stock with deferred delivery in the futures market verses buying it in the spot market with immediate delivery and “carrying” it in inventory

## Forward versus Futures Pricing

Strictly speaking the spot-futures parity applies only to forwards because the cash-flows accrue only at settlement and not through the daily mark-to-market process that forwards undergo. Futures prices will deviate from parity values when marking to market gives a systematic advantage to either the long to short position. If marking to market tends to favour the long postion, for example, the futures price should exceed the forward price, because the long position will be willing to pay a premium for the advantage of marking to market.

When will marking to market favour either a long or short trader? A trader will benefit if daily settlements are received when the interest rate is high and paid when the interest rate is low. Receiving payments when the interest rate is high allows investment of proceeds at a high rate

Therefore,  a positive correlation between interest rates and changes in future prices implies that the “fair” futures price will exceed the forward price. For most contracts, the co-variance between futures prices and interest rates is so low that the difference between futures and forward prices will be negligible. However, contracts on long term-fixed-income securities are an import exception to the this rule. In this case, because prices have a high correlation with interest rates, the co-variance can be large enough to generate a meaningful spread between forward and future prices.

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