Common Characteristics of Futures and Forwards Forward Commitments 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.

Forward Contracts Forward Contracts A forward is an agreement between two counterparties a buyer and seller. The buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase. Key features of forward contracts are:

Highly customized - Counterparties can determine and define the terms and features to fit their specific needs, including when delivery will take place and the exact identity of the underlying asset.

All parties are exposed to counterparty default risk This is the risk that the other party may not make the required delivery or payment.

Transactions take place in large, private and largely unregulated markets consisting of banks, investment banks, government and corporations. Underlying assets can be a stocks, bonds, foreign currencies,

commodities or some combination thereof. The underlying asset could even be interest rates.

They tend to be held to maturity and have little or no market liquidity. Any commitment between two parties to trade an asset in the future is a forward contract.

Example: Forward Contracts Let's assume that you have just taken up sailing and like it so well that you expect you might buy your own sailboat in 12 months. Your sailing buddy, John, owns a sailboat but expects to upgrade to a newer, larger model in 12 months. You and John could enter into a forward contract in which you agree to buy John's boat for $150,000 and he agrees to sell it to you in 12 months for that price. In this scenario, as the buyer, you have entered a long forward contract. Conversely, John, the seller will have the short forward contract. At the end of one year, you find that the current market valuation of John's sailboat is $165,000. Because John is obliged to sell his boat to you for only $150,000, you will have effectively made a profit of $15,000. (You can buy the boat from John for $150,000 and immediately sell it for $165,000.) John, unfortunately, has lost $35,000 in potential proceeds from the transaction.

Future Contract Future contracts are also agreements between two parties in which the buyer agrees to buy an underlying asset from the other party (the seller). The delivery of the asset occurs at a later time, but the price is determined at the time of purchase.

Terms and conditions are standardized. Trading takes place on a formal exchange wherein the exchange provides a place to engage in these transactions and sets a mechanism for the parties to trade these contracts.

There is no default risk because the exchange acts as a counterparty, guaranteeing delivery and payment by use of a clearing house. The clearing house protects itself from default by requiring its counterparties to settle gains and losses or mark to market their positions on a daily basis.

Futures are highly standardized, have deep liquidity in their markets and trade on an exchange. An investor can offset his or her future position by engaging in an opposite transaction before the stated maturity of the contract.

Example: Future Contracts Let's assume that in September the spot or current price for hydroponic tomatoes is $3.25 per bushel and the futures price is $3.50. A tomato farmer is trying to secure a selling price for his next crop, while McDonald's is trying to secure a buying price in order to determine how much to charge for a Big Mac next year. The farmer and the corporation can enter into a futures contract requiring the delivery of 5 million bushels of tomatoes to McDonald's in December at a price of $3.50 per bushel. The contract locks in a price for both parties. It is this contract and not the grain per se - that can then be bought and sold in the futures market. In this scenario, the farmer is the holder of the short position (he has agreed to

sell the underlying asset tomatoes) and McDonald's is the holder of the long position (it has agreed to buy the asset). The price of the contract is 5 million bushels at $3.50 per bushel. The profits and losses of a futures contract are calculated on a daily basis. In our example, suppose the price on futures contracts for tomatoes increases to $4 per bushel the day after the farmer and McDonald's enter into their futures contract of $3.50 per bushel. The farmer, as the holder of the short position, has lost $0.50 per bushel because the selling price just increased from the future price at which he is obliged to sell his tomatoes. McDonald's has profited by $0.50 per bushel. On the day the price change occurs, the farmer's account is debited $2.5 million ($0.50 per bushel x 5 million bushels) and McDonald's is credited the same amount. Because the market moves daily, futures positions are settled daily as well. Gains and losses from each day's trading are deducted or credited to each party's account. At the expiration of a futures contract, the spot and futures prices normally converge. Most transactions in the futures market are settled in cash, and the actual physical commodity is bought or sold in the cash market. For example, let's suppose that at the expiration date in December there is a blight that decimates the tomato crop and the spot price rises to $5.50 a bushel. McDonald's has a gain of $2 per bushel on its futures contract but it still has to buy tomatoes. The company's $10 million gain ($2 per bushel x 5 million bushels) will be offset against the higher cost of tomatoes on the spot market. Likewise, the farmer's loss of $10 million is offset against the higher price for which he can now sell his tomatoes. Read more: http://www.investopedia.com/study-guide/cfa-exam/level-

1/derivatives/cfa5.asp#ixzz1WiqdyxYq

http://www.investopedia.com/study-guide/cfa-exam/level1/derivatives/cfa2.asp#axzz1WinvEEQH Closing and Terminating a Futures Position Closing Out A Futures Position As we discussed previously, when a trader goes long or short on a position, he can close his position prior to expiration by executing a reversing transaction that is exactly the same as his original trade. The clearing house views the trader as holding a long and short position that offset each other, causing the trader's position to be flat. This is the same as having no position at all. Example: Closing a Futures Position You have entered a long position in 30 December S& P 250 contracts, in August. Come September, you decide that you want to close your position before the contract expires. To accomplish this, you must short, or sell the 30 December S & P 250 contract. The clearing house sees your position as flat because you are now long and short the same amount and type of contract. Terminating Futures Contracts

Close-Out (offset) at Expiration - If a trader holds a long position, she can go short the same contract with regards to the terms of the original trade and vice versa for the short position trader. Prices may differ because of market conditions. Delivery - Here, the long position keeps the position open at the end of trading on the expiration date. This requires the long holder to accept delivery of the underlying asset and pay the short position the settlement price from the previous day. Equivalent Cash Settlement - Some contracts are designated as cash-settle contracts. At expiration, the trader keeps his position open. When the contract expires, the margin account is marked to market and the gain is posted in the account. The reason that a gain is posted is because in most cases the trader would close out the position prior to expiration if it is a loser. Exchange-for-Physicals These are used for futures participants. Here the long and short holders arrange alternative delivery procedures. For example, if the exchange requires the physical delivery of the asset in Chicago, the parties may agree to make settlement outside of the required area, say Pittsburgh. The parties will have to report to the Chicago Board of Trade that the transaction was settled outside the normal procedures. This is satisfactory to the exchange.

Read more: http://www.investopedia.com/study-guide/cfa-exam/level1/derivatives/cfa24.asp#ixzz1Wizm6nMh

Purposes and Benefits of Derivatives Purposes and Benefits Today's sophisticated international markets have helped foster the rapid growth in derivative instruments. In the hands of knowledgeable investors, derivatives can derive profit from:

Changes in interest rates and equity markets around the world Currency exchange rate shifts Changes in global supply and demand for commodities such as agricultural products, precious and industrial metals, and energy products such as oil and natural gas

Adding some of the wide variety of derivative instruments available to a traditional portfolio of investments can provide global diversification in financial instruments and currencies, help hedge against inflation and deflation, and generate returns that are not correlated with more traditional investments. The two most widely recognized benefits attributed to derivative instruments are price discovery and risk management. 1. Price Discovery Futures market prices depend on a continuous flow of information from around the world and require a high degree of transparency. A broad range of factors (climatic conditions, political situations, debt default, refugee displacement, land

reclamation and environmental health, for example) impact supply and demand of assets (commodities in particular) and thus the current and future prices of the underlying asset on which the derivative contract is based. This kind of information and the way people absorb it constantly changes the price of a commodity. This process is known as price discovery.
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With some futures markets, the underlying assets can be geographically dispersed, having many spot (or current) prices in existence. The price of the contract with the shortest time to expiration often serves as a proxy for the underlying asset. Second, the price of all future contracts serve as prices that can be accepted by those who trade the contracts in lieu of facing the risk of uncertain future prices. Options also aid in price discovery, not in absolute price terms, but in the way the market participants view the volatility of the markets. This is because options are a different form of hedging in that they protect investors against losses while allowing them to participate in the asset's gains.

As we will see later, if investors think that the markets will be volatile, the prices of options contracts will increase. This concept will be explained later. 2. Risk Management This could be the most important purpose of the derivatives market. Risk management is the process of identifying the desired level of risk, identifying the actual level of risk and altering the latter to equal the former. This process can fall into the categories of hedging and speculation. Hedging has traditionally been defined as a strategy for reducing the risk in holding a market position while speculation referred to taking a position in the way the markets will move. Today, hedging and speculation strategies, along

with derivatives, are useful tools or techniques that enable companies to more effectively manage risk. 3. They Improve Market Efficiency for the Underlying Asset For example, investors who want exposure to the S&P 500 can buy an S&P 500 stock index fund or replicate the fund by buying S&P 500 futures and investing in risk-free bonds. Either of these methods will give them exposure to the index without the expense of purchasing all the underlying assets in the S&P 500. If the cost of implementing these two strategies is the same, investors will be neutral as to which they choose. If there is a discrepancy between the prices, investors will sell the richer asset and buy the cheaper one until prices reach equilibrium. In this context, derivatives create market efficiency. 4. Derivatives Also Help Reduce Market Transaction Costs Because derivatives are a form of insurance or risk management, the cost of trading in them has to be low or investors will not find it economically sound to purchase such "insurance" for their poitions