Page 47 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes price of the asset on the contract maturity date. Added to this, the futures contract entails the
following two obligations, both of which help to minimize the default (or credit) risk inherent
in forward contracts.

Did u know? How is a futures contract different from a forward contract?
1. The value of the futures contract is 'settled' (i.e., paid or received) at the end of each
trading day. In the language of the futures markets, the futures contract is 'cash
settled', or 'mark/marked-to-market' daily. The marked-to-market provision
effectively reduces the performance period of the contract to a day, thereby
minimizing the risk of default.
2. Both buyers and sellers are required to post a performance bond called 'margin'. At
the end of each trading day, gains and losses are added to and taken away from the
margin account, respectively. The margin account must remain above an agreed
upon minimum or the account will be closed. The margin provision prevents the
depletion of accounts, which, in turn, largely eliminates the risk of default.
The following are the distinguishing features between forwards and futures:
1. Delivery of the underlying is the hallmark of a forward contract. To the contrary the vast
majority of futures contracts – even though they provide for delivery – are satisfied by
entering into an offsetting contract or selling the contract on the exchange – namely, no
delivery. This is the primary distinguishing feature of the forwards as given by the CFTC.
Forwards also typically have been described by reference to the commercial natures of the
counterparties which have the capacity to make or take delivery.
2. A forward contract is entered into for commercial purposes related to the business of the
party wanting to enter into the forward. The producer, processor, fabricator, refiner, or
merchandiser may want to purchase or sell a commodity for deferred shipment or delivery
as part of the conduct of its business. In contrast, futures contracts are undertaken principally
to assume or shift price risk without transferring the underlying commodity.
3. A forward contract is privately and individually negotiated between two principals. A
futures contract is an exchange-traded contract, with standardized provisions including:
commodity units; margin requirements related to price movements; clearing organizations
that guarantee counterparty performance; open and competitive trading on exchanges;
and public dissemination of price.

4. A forward contract generally is not assignable without the consent of the contracting
parties and does not provide for an exchange-style offset. A futures contract is fungible,
because of its standardized form, and hence can be traded on an exchange.
5. With a forward contract, no clearing house, no settlement system, and – according to
CFTC – no variation margining is involved. All of these features apply to a futures contract.
Futures contracts are standardized contracts that are traded on organized futures markets. Because
contract sizes and maturities are standardized, all participants in the market are familiar with
the types of contracts available, and trading is facilitated. Forward contracts, on the other hand,
are private deals between two individuals who can sign any type of contract they agree on.
The organization of futures trading with a clearing house reduces the default risks of trading.
The exchange members, in effect, guarantee both sides of a contract. In contrast, a forward
contract is a private deal between two parties and is subject to the risk that either side may
default on the terms of the agreement.

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