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M6A — Securities & Futures Product Knowledge — Specified Investment Products

Derivatives — Futures & Forwards

A forward and a futures contract are both agreements to buy or sell an underlying asset at a price fixed today for delivery/settlement on a future date; forwards are private, customised OTC deals, while futures are standardised, exchange-traded and centrally cleared with daily margining.

8 sections~4 min read

Must-know for the exam

Forwards and futures both OBLIGATE both parties to trade an underlying at a price fixed today for future delivery; no premium is paid up front (unlike an option).
Forward = OTC, customised, bilateral, carries counterparty/credit risk, usually settled at maturity. Futures = exchange-traded, standardised, centrally cleared, marked-to-market daily.
Central clearing novates the futures contract to a clearing house that becomes counterparty to both sides, largely removing counterparty risk.
LONG profits when price RISES; SHORT profits when price FALLS. Payoffs are linear, symmetric and zero-sum between the two parties.
Initial margin is a performance bond posted by BOTH sides; it is not a down-payment on the asset.
Marking-to-market credits/debits the day's gain or loss daily; variation margin restores the account after losses.
A margin call is triggered when the balance falls below the maintenance margin; failure to top up leads to the position being closed out.
Cost of carry: Forward price ≈ Spot + financing + storage − income/yield. As expiry nears the futures price CONVERGES to spot.
CONTANGO = futures above spot (positive net carry, upward curve); BACKWARDATION = futures below spot (high yield/convenience, downward curve).
Basis = spot − futures; it narrows to zero at expiry. Basis risk makes hedges with a mismatched asset or date imperfect.
Hedging offsets an existing exposure to lock in a price; speculation takes on risk to profit from an expected move and adds liquidity.
Leverage: only a small margin controls a large notional, so gains and losses are magnified and losses can EXCEED the initial deposit.
Main risk of a FORWARD is counterparty default; a key risk of FUTURES is meeting margin calls in cash.
As a Specified Investment Product (SIP), futures can only be sold after a Customer Knowledge Assessment (CKA/CAR) — see the SFA/SIP framework topic.

What forwards and futures are

A FORWARD contract is a private agreement between two parties to buy/sell a specified quantity of an underlying asset at a price agreed today (the forward or delivery price), with settlement on a fixed future date. Its value is DERIVED from that underlying (a currency, commodity, interest rate, share or index).

A FUTURES contract is economically the same promise — buy/sell an underlying at a set price for future delivery — but it is a STANDARDISED contract traded on an organised exchange and settled through a central clearing house.

In both, NO premium changes hands at inception (unlike an option). Both parties are OBLIGATED to perform: unlike an option there is no right to walk away. The contract is entered at a price that makes its initial value approximately zero to both sides.

Key terms: the contract size (quantity of underlying per contract), the delivery/expiry date, the futures/forward price, and — for futures — the tick size (minimum price movement) and tick value.

Forwards vs futures — the core distinctions

Both fix a price today for future delivery, but they differ across almost every practical dimension:

•TRADING VENUE: forwards are OTC (over-the-counter), negotiated bilaterally; futures trade on a regulated exchange.
•STANDARDISATION: forwards are fully CUSTOMISED (size, date, underlying grade tailored to the parties); futures are STANDARDISED in size, quality and delivery dates set by the exchange.
•CLEARING & COUNTERPARTY: futures are novated to a central CLEARING HOUSE that becomes counterparty to both sides, largely removing counterparty risk; forwards expose each party to the other's DEFAULT (counterparty/credit risk).
•MARGIN & CASH FLOW: futures require initial margin and are MARKED-TO-MARKET daily with variation margin; forwards typically involve no daily cash flow (though collateral/CSA arrangements may apply), with gain or loss realised at maturity.
•LIQUIDITY & EXIT: a futures position can be closed easily before expiry by taking an equal and opposite trade; a forward is harder to unwind and usually runs to maturity.

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Traps that cost marks

Treating a futures/forward like an option that carries an up-front premium and a right to walk away.
Swapping the futures characteristics (standardised, cleared, margined) onto the forward.
Confusing the long (gains on a rise) with the short (gains on a fall).
Reading margin as a partial payment for the asset rather than a performance bond.
Assuming clearing guarantees profit or removes the need for margin.
Reversing contango and backwardation.
Forgetting to add storage ($104), or subtracting carry instead of adding it ($95).
Adding the dividend instead of subtracting it ($51.50) or adding both components ($53.50).

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Exam-style questions

A commodity's futures curve is in BACKWARDATION. This is MOST consistent withAnswer explained →A 'convenience yield' on a physical commodity refers toAnswer explained →The principal risk that most distinguishes a FORWARD from an exchange-traded future isAnswer explained →Initial margin differs fundamentally from an option premium because it isAnswer explained →Setting the MAINTENANCE margin below the initial margin serves toAnswer explained →

Next →Derivatives — Options