Derivative basics and pricing - Forwards and futures mechani...

Learning Outcomes

This article explains the core mechanics and pricing of forward and futures contracts in an exam-focused way. It describes how these derivative contracts are structured, including contract terms, reference assets, maturity, and settlement provisions, and distinguishes clearly between over-the-counter forwards and exchange-traded futures. It details how to compute and interpret payoffs for long and short positions in forwards and futures, linking the payoff logic to typical CFA Level I question formats. The article explains margin terminology, initial and maintenance margin, margin calls, and the daily marking-to-market process, emphasizing how these features reduce counterparty risk through the role of the clearing house. It examines delivery versus cash settlement, the practical likelihood of physical delivery, and how traders close or offset positions before expiry. Finally, it discusses how forwards and futures are used in basic hedging strategies, highlights key differences in liquidity, flexibility, and risk between the two instruments, and shows how to apply these comparisons to multiple-choice scenarios that test conceptual understanding and simple numerical calculations.

CFA Level 1 Syllabus

For the CFA Level 1 exam, you are expected to understand the foundational aspects of derivatives, especially focusing on the mechanics and pricing of forwards and futures, with a focus on the following syllabus points:

• Define forwards and futures and describe their key features and differences
• Explain margining, daily settlement, and delivery procedures for futures
• Calculate the payoff and basic pricing for forward and futures positions
• Identify counterparty risks and practical uses in risk management

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What is the primary difference between a forward contract and a futures contract regarding settlement and counterparty risk?
2. How does initial margin work in a futures contract, and why is daily marking to market important?
3. If a firm takes a long position in a one-year forward contract on gold at an agreed price of $2,000 per ounce, and at expiry gold is at $2,100 per ounce, what is its payoff?
4. Why are futures typically preferred to forwards for managing short-term price risk?

Introduction

Derivative contracts are central to risk management and speculation in financial markets. Understanding the fundamental mechanics of forwards and futures is essential for success in the CFA examination and practical finance roles.

Key Term: derivative
A financial contract whose value derives from the price of a reference asset, rate, or index.

FORWARDS AND FUTURES: STRUCTURE AND BASIC FEATURES

Forward and futures contracts are agreements to transact on an asset at a specified future date and price, allowing investors or firms to manage price risk exposure.

Key Term: forward contract
A customizable agreement between two counterparties to buy or sell an asset at a specified price on a set future date.

Key Term: futures contract
A standardized agreement traded on an exchange to buy or sell an asset at a predetermined price and future date.

Forwards are private, over-the-counter contracts. Each is tailored to suit the counterparties. Settlement and delivery happen only at expiry, and no cash changes hands initially. Credit risk exists because each party must rely on the other fulfilling the contract.

Futures are exchange-traded and standardized. Futures contracts are backed by a clearing house, and daily cash flows arise due to marking to market. This process, along with margin requirements, significantly reduces counterparty risk.

Key Term: marking to market
The daily adjustment of a futures position to reflect gains and losses from changes in the contract's price.

Key Term: margin
Collateral required by an exchange to cover potential losses on a futures contract.

FORWARD CONTRACTS: MECHANICS AND PAYOFFS

A forward contract specifies the reference asset, forward price, maturity date, contract size, and settlement procedure. No money changes hands at inception. At maturity, the contract settles in cash or through delivery of the reference asset.

The buyer (long) profits if the asset's price at expiry exceeds the forward price, while the seller (short) gains if it is below the forward price.

Worked Example 1.1

A wheat producer sells 10,000 bushels forward at $5.00/bushel for delivery in 6 months. At expiry, the market price is $5.30/bushel.

Answer:
The producer, as the short, delivers wheat and receives $5.00/bushel regardless of the spot price. The short pays an opportunity cost by settling at a below-market price. Gain/loss = Forward price – Spot price × quantity = ($5.00 – $5.30) × 10,000 = –$3,000. The short has a $3,000 loss; the long gains $3,000.

FUTURES CONTRACTS: MARGINING AND DAILY SETTLEMENT

Futures contracts are highly standardized, specifying quantity, quality, delivery month, and exchange location. Each participant must post initial margin—a deposit with the exchange or clearing house—as insurance against potential losses. The exchange revalues every contract daily (marking to market), transferring gains and losses between buyers and sellers.

If losses reduce margin balance below a defined maintenance margin, a margin call is issued, and additional funds are required to restore margin to the initial level.

Key Term: margin call
A demand for additional funds to restore margin to required minimums when losses reduce account balance.

This process greatly lowers default risk, as counterparties settle gains or losses each day rather than solely at expiry.

Worked Example 1.2

An investor goes long 2 gold futures contracts (100 oz each) at $1,950/oz. Initial margin is $8,000 per contract. The next day, gold rises to $1,960/oz.

Answer:
Gain = ($1,960 – $1,950) × 2 × 100 = $2,000. The investor receives $2,000 in the margin account by close of the day. No margin call is required if account balance exceeds maintenance margin.

FORWARDS VS. FUTURES: KEY DIFFERENCES

Key Term: clearing house
An intermediary guaranteeing contract performance in exchange-traded derivatives.

Futures also provide easy exit by closing positions before maturity, while forwards require negotiation or offsetting positions with the original party.

DELIVERY AND SETTLEMENT

Most futures contracts do not result in physical delivery; instead, traders close out positions before expiry, realizing gains or losses in cash. Forwards may stipulate physical delivery or cash settlement. Physical settlement occurs according to contract terms at maturity.

Exam Warning

Futures contracts are marked to market and settled daily, so the settlement price is not solely the spot price at expiry. Contrast this with forwards, which settle in one lump sum at contract maturity.

Summary

Forwards and futures are both agreements to transact in the future at a preset price, but they differ greatly in standardization, trading venue, margining, daily settlement, and counterparty risk. Margins and the daily mark-to-market process are central to futures, reducing default risk and increasing market liquidity. Understanding these differences is essential for CFA exam success and professional practice.

Key Point Checklist

This article has covered the following key knowledge points:

• Define forwards and futures and distinguish their structure and mechanics
• Explain the roles of margin and marking to market for futures
• Calculate payoffs for forward and futures positions
• Recognize counterparty risk and default mitigation features
• Compare settlement, delivery, and exit procedures

Key Terms and Concepts

• derivative
• forward contract
• futures contract
• marking to market
• margin
• margin call
• clearing house