CFA Program Level I

Forwards vs futures: CFA Level I differences explained

Both fix a price today for a trade at a later date. A forward is a private over-the-counter contract with custom terms that settles once, at maturity, so each party bears the other's credit risk. A futures contract trades on an exchange, its counterparty exposure is taken on by a clearinghouse, and it is marked to market daily through margin accounts.

The differences that matter

Where they trade: futures trade on organised exchanges; forwards are privately negotiated over the counter.

Terms: forwards are customised. The OCC notes that, unlike exchange-traded instruments, OTC contracts can be hard to transfer or unwind because of their customised nature; they can usually be cancelled only by agreement with the counterparty or by assignment.

Credit risk: for exchange-traded contracts, the clearinghouse takes on counterparty exposure and manages it with margin and netting. In a forward, each party relies on the other to perform.

Cash flow timing: futures are marked to market daily and margin balances change throughout the contract's life. A forward pays out only at maturity.

How futures margin works

Initial margin is the amount required to open the position. Maintenance margin is the minimum balance that must be kept.

Gains and losses are credited or debited to the margin account each day.

If the balance falls below maintenance margin, the trader must post variation margin to bring the balance back to the initial margin, not just to the maintenance level.

Worked example: a margin call

A trader buys one futures contract on 5,000 units. Initial margin is USD8,000; maintenance margin is USD6,000.

Day 1: the futures price falls USD0.30. Loss = 0.30 x 5,000 = USD1,500. Balance = 6,500, above 6,000, so no call.

Day 2: the price falls another USD0.20. Loss = USD1,000. Balance = 5,500, below 6,000. Variation margin = 8,000 - 5,500 = USD2,500.

A forward on the same terms would have no cash flows until maturity, when the whole USD2,500 loss would be settled at once if prices stayed there.

Are futures and forward prices the same?

Very nearly. Federal Reserve research notes that when the overnight funding rate is correlated with the futures price, which is very likely for interest rate futures, daily settlement creates a convexity adjustment between the futures and forward prices.

Numerical calibrations show this adjustment is small. For CFA Level I, treat the prices as close but not identical, and know that daily settlement is the reason they differ.

Where the exam catches people

Believing margin calls restore the account to the maintenance level: variation margin brings it back to the initial margin.
Believing forwards are guaranteed by a clearinghouse: exchange clearing applies to futures; a bilateral forward leaves each party exposed to the other.
Believing a forward settles daily like a futures contract: it pays out only at maturity.
Believing futures and forward prices are always identical: daily marking to market creates a small convexity adjustment when rates are correlated with the futures price.
Believing a forward is easy to exit early: customised OTC contracts usually need the counterparty's agreement, an assignment, or an offsetting trade.

Written from CFA Institute's documentation

Try 3 questions on this

Pick an answer to see why each option is right or wrong.

A grain processor can hedge its wheat purchases either with a private forward agreement with a merchant or with futures on a regulated exchange. Which statement about the default risk the processor faces is most accurate?
Right. In the game that’s Renown for your Derivatives building.
Not that one: A is right. In the game your Derivatives building would lose a little Renown, and this question would come back later.
The answerA.It is lower on the futures, as margin and daily mark-to-market protect both partiesFutures positions are protected by performance bonds (margin) and by daily mark-to-market debits and credits to margin accounts, which protect buyers and sellers against contract default.Your answerB.It is similar for forwards and futures, as each fixes a price for later deliveryBoth contracts fix a price for later delivery, but only the futures carries performance bonds and daily settlement through the clearing system, so the default risk is not the same.Your answerC.It is lower on the forward, as an exchange clearing house guarantees forward agreementsA forward is a private cash-market agreement between buyer and seller; the clearing house clears and settles trades made through an exchange, which is the futures side.
Show the full explanation and doc quotes
A forward is a private agreement between a buyer and a seller, so the processor relies on the merchant's performance.
Written from www.cmegroup.com/education/glossary
A trader buys two futures contracts, each on 1,000 units of a commodity. Initial margin is USD6,000 per contract and maintenance margin is USD4,500 per contract. The next day the futures price falls by USD2.00 per unit. The amount the trader must deposit is closest to:
Right. In the game that’s Renown for your Derivatives building.
Not that one: C is right. In the game your Derivatives building would lose a little Renown, and this question would come back later.
Your answerA.USD1,000Restoring the account only to maintenance, 9,000 − 8,000 = USD1,000, is too little: a margin call requires the balance to be brought back to the initial margin of USD12,000.Your answerB.USD2,000USD2,000 is the shortfall for one contract (6,000 − 4,000). The trader holds two contracts, so the loss and the required deposit are both USD4,000.The answerC.USD4,000Initial margin on two contracts is 2 × 6,000 = USD12,000; maintenance is 2 × 4,500 = USD9,000. The loss is 2.00 × 1,000 × 2 = USD4,000, leaving 12,000 − 4,000 = USD8,000, below maintenance.
Show the full explanation and doc quotes
The trader must post variation margin to bring the balance back to the initial margin: 12,000 − 8,000 = USD4,000.
Written from www.federalreserve.gov/econresdata/feds/2014/files/201486pap.pdf
An analyst compares a futures contract on a short-term interest rate, which is marked to market daily, with an over-the-counter forward contract on the same rate and period, which settles only at maturity. The overnight funding rate is correlated with the futures price. Which statement about the two contracts' prices is most accurate?
Right. In the game that’s Renown for your Derivatives building.
Not that one: A is right. In the game your Derivatives building would lose a little Renown, and this question would come back later.
The answerA.They differ slightly, because daily settlement creates a small convexity adjustmentFutures and forward prices are very close to equivalent. The difference is that the futures is marked to market daily and the over-the-counter forward is not.Your answerB.They are equal, because both contracts fix the same rate for the same periodBoth contracts fix the same rate for the same period, but only the futures settles daily. With the funding rate correlated with the futures price, gains and losses are financed at different rates, which opens a convexity adjustment, so the prices are not exactly equal.Your answerC.They differ widely, because daily settlement removes the futures' exposure to ratesThe futures still carries the exposure to the rate; daily settlement only changes when gains and losses are paid. The resulting convexity adjustment is small in calibrations, so the prices stay very close rather than far apart.
Show the full explanation and doc quotes
When the overnight funding rate is correlated with the futures price, as is very likely for interest rate futures, daily settlement produces a convexity adjustment between the two prices, and numerical calibrations show it is small.
Written from www.federalreserve.gov/pubs/ifdp/2004/808/ifdp808.pdf