There are two types of derivative classes: forward commitments and contingency claims. Forward commitments represent the promise to transact at one or more agreed-upon transaction dates. They outline the identity and quantity of the underlying, the manner of the transaction execution(s), and the forward price(s). In this article, we shall focus on the forward commitments. The three main forward commitments are forwards, futures, and swaps. Below details more of each contract type.
Forward contracts are exchanged OTC in which the buyer promises to purchase the underlying or its cash equivalent from the seller at a specific expiration date in the future. The seller in turn promises to deliver the underlying or the cash equivalent to the buyer at the same expiration date. Cash-settled forwards are also known as non-deliverable forwards (NFDs) or contracts for differences. Transaction costs are different for NFDs and physical-delivery forwards.
The payoffs for the long holder and short holder are in a zero-sum game: that is, the long payoff is ST - F0(T) and the short payoff is F0(T) - ST. Forward contracts are worth 0 at the start of the contract initialization but will deviate from zero in either direction as times passes. In fact, forward contract premiums almost always finish non-zero at expiration.
Future contracts are traded on a formal exchange and are essentially the exchange-traded version of forwards with slight differences. They can be both cash-settled or finish with physical delivery. The most significant difference between futures and forwards is that futures mandate that both parties receive their gain or loss daily via daily settlement.
Daily settlement is the end-of-day process of calculating the settlement price via averaging the last few trades of identical contracts before moving the cash difference of that day’s settlement price and the previous day’s to and from both parties’ margin accounts. For example, a futures contract initiated on day 0 has a forward price of $100 and on has a settlement price of $110 on day 1. Then the buyer’s margin account will be credited with $10 while the seller’s margin account will be charged $10. This daily settlement process continues until expiration date. From a long holder’s perspective, the entire daily settlement process results in a series of daily cash flows as follows:
F1(T) - F0(T) on day 1
F2(T) – F1(T) on day 2
FT(T) – FT-1(T) on day T
The total cash flow flowing into the long holder’s margin account is therefore FT(T) – F0(T). But FT(T) is the spot price of the underlying ST since the underlying will be delivered on day T. So the total long cash flow can alternatively be written as ST – F0(T), which is the same formula used to calculate the forward contract long payoff.
There are a couple of procedures which clearinghouses uphold to reduce credit risk in an exchange-traded futures market:
1. Margin accounts are useful for clearinghouses to provide a credit guarantee to either party should a default occur. Both parties must deposit initial margins in cash (not borrowed) into the margin account for the purpose of the daily settlement. Initial margins in margin accounts are normally less than 10% of the future price, while a maintenance margin is imposed which acts as a minimum threshold for margin accounts. If margin accounts fall below the maintenance margin threshold, the relevant party has two options: a) add more cash (not borrowed) to the margin account to make up to the initial margin, or b) close their position with the future contract as soon as possible while making the daily settlement payments until closure success.
2. In fast moving markets, clearinghouses reserve the right to make margin calls during the day. In the event of a default, the clearinghouse will use its insurance fund to pay the winning party. Should its insurance fund dry up too, clearinghouses can also levy a tax on market participants.
In support of reducing credit risk, some future contracts also have price limits. These are rules that state a price band with reference to the previous day’s settlement price in which these future contracts can trade. A scenario in which traders want to trade beyond the price limit is what is known as limit up, and a scenario in which traders want to trade below the price limit is what is known as limit down. When the market hits the limits and trading stops, it is called a locked limit. Normally, the exchange will endeavour to expand on these limits the next day. Price limits are used to prevent significant price swings and reduce potential for defaults.
Future contracts are worth 0 at the start of the contract initialization but will deviate from zero in either direction as times passes and resets to 0 with each end-of-day settlement.
Forwards vs Futures
Futures give clearinghouses greater flexibility to manage credit risk since the gains and losses are realized in multiple smaller amounts versus the one-lump large loss/gain at expiration with forward contracts. Moreover, futures can provide better regulation and greater transparency in the formal futures exchange. However, it is more difficult to hedge with a futures strategy.
Forwards are OTC contracts and therefore more private and flexible. A major disadvantage, however, is that the party could default with a big loss at the expiry date.
Swaps are OTC derivatives in which one party pays out a variable cash flow and the other part pays either a variable cash flow or a fixed cash flow. The variable cash flow is based on the underlying movement or a rate. Examples include interest-rate swaps (eg. vanilla fixed-for-floating interest rate swaps) and overnight index swaps.
The fixed-for-floating interest rate swap is the most common swap. Suppose a company borrows from a bank at a floating rate but would ideally prefer to pay out a fixed rate in order to better predict and manage its internal cash flows. It then goes to an agent which can provide a fixed-for-floating interest swap in which the company pays the dealer a fixed interest rate and the dealer in turn pays the company the floating rate which exactly matches the terms of the original bank loan.
Unlike loans, swaps do not have principals. However, they do have a notational principal. The credit risk of a swap is generally less than that of a loan because the notational value is not exchanged.
Swap contracts are worth 0 at the start of the contract initialization but will deviate from zero in either direction as times passes.