CFA Level 1
Derivatives - Common Characteristics of Futures and Forwards
A forward commitment is a contract between two (or more) parties who agree to engage in a transaction at a later date and at a specific price, which is given at the start of the contract. It is a customized, privately negotiated agreement to exchange an asset or cash flows at a specified future date at a price agreed on at the trade date. In its simplest form, it is a trade that is agreed to at one point in time but will take place at some later time. For example, two parties might agree today to exchange 500,000 barrels of crude oil for $42.08 a barrel three months from today. Entering a forward contract typically does not require the payment of a fee.
There are two major types of forward commitments:
- Forward contracts, or forwards, are OTC-traded derivatives with customized terms and features.
- Futures contract, or futures, are exchange-traded derivatives with standardized terms.
Futures and forwards share some common characteristics:
- Both futures and forwards are firm and binding agreements to act at a later date. In most cases this means exchanging an asset at a specific price sometime in the future.
- Both types of derivatives obligate the parties to make a contract to complete the transaction or offset the transaction by engaging in anther transaction that settles each party's obligation to the other. Physical settlement occurs when the actual underlying asset is delivered in exchange for the agreed-upon price. In cases where the contracts are entered into for purely financial reasons (i.e. the engaged parties have no interest in taking possession of the underlying asset), the derivative may be cash settled with a single payment equal to the market value of the derivative at its maturity or expiration.
- Both types of derivatives are considered leveraged instruments because for little or no cash outlay, an investor can profit from price movements in the underlying asset without having to immediately pay for, hold or warehouse that asset.
- They offer a convenient means of hedging or speculating. For example, a rancher can conveniently hedge his grain costs by purchasing corn several months forward. The hedge eliminates price exposure, and it doesn't require an initial outlay of funds to purchase the grain. The rancher is hedged without having to take delivery of or store the grain until it is needed. The rancher doesn't even have to enter into the forward with the ultimate supplier of the grain and there is little or no initial cash outlay.
- Both physical settlement and cash settlement options can be keyed to a wide variety of underlying assets including commodities, short-term debt, Eurodollar deposits, gold, foreign exchange, the S&P 500 stock index, etc.
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