FORWARD AND FUTURES

CONTRACTS
 Forward Contracts

• Definition
• An agreement between two counterparts that
fixes the terms of an exchange that will take
place between them at some future date.
• The contract specifies

• What is being exchanged e.g. cash for goods, cash for

service; good for good, cash for cash etc.
• The date (or range of dates) in the future at which the
exchange takes place.

• In other words, a forward contract locks in the price today

of an exchange that will take place at some future date. It
is a contract for forward delivery rather than a contract for
immediate or cash delivery or spot delivery.
• Advantages Vs futures contracts
• The contract is tailor made to the specific requirements of the two counterparties.

• Disadvantages
•
• Cannot be cancelled without the agreement of the two counterparties.
• Obligation under the agreement cannot be generally transferred to a third party i.e. the
contract is neither very liquid nor very marketable.
• There is no guarantee that the counterparty will not default and fail to deliver his obligations
under the contract. This is more likely to happen the further away the spot price, at time of
delivery, is from the forward price.

• If the spot price at delivery is higher than the forward price the counterparty taking delivery
(buyer) gains.
•
• If the spot price is lower than the forward price, the counterparty making delivery (seller)
gains.
 Futures Contract

• Definition – A marketable agreement between

two counterparties that fixes the terms of an
exchange that will take place between them at
some future date.
• However it differs from the forward contract
in that it was designed to remove most of the
disadvantages of the forward contract viz.
•
• Features
•
• They are standardized agreements to exchange:
• Specific types of goods – e.g. stock
• In specific amounts
• At specific future delivery/maturity dates e.g. there may be only four contracts
traded per year i.e. March, June, September and December.
• All this means the details of the contracts are not negotiable as with forward
contracts.
• Futures contracts eliminate the problems of illiquidity and credit risk by
• Introducing a clearing house
• A system of marking to market and margin payments
• A system of price limits.
 Clearing House

• Guarantees fulfillment on all contracts by

intervening in all transactions and becoming
the formal counterparty to every transaction.
The only credit risk is, therefore, with the
clearing house.
• The clearing house, however, withstands all
credit risk involved in being the effective
counterparty to every transaction by using the
systems of:
 Daily Marking to Market:

• his requires that at end of trading day, profit

or loss accruing to counterparties a result of
that day’s change in price be paid or received.
• Failure to pay daily losses results in default
and the closure of the contract against the
defaulting counterparty.
• Credit risk to the clearing house has now been
minimized.
 Initial Margin

• Is a deposit payment that both counter parties

must pay to further cover the credit risk
assumed by the clearing house. It is set to
equal the maximum possible daily loss.
• As the margin account falls to below a certain
level called maintenance margin level,
additional payments, called variation margins
must be paid.