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10.6 Forwards And Futures

Comprehensive guide distinguishing between forwards and futures contracts, used strategies, and categorization of underlying assets for investors preparing for the Canadian Securities Course certification exam.

Overview

Forwards and Futures

A forward is a contractual agreement between two parties: a buyer and a seller. Here, the buyer agrees to purchase an underlying asset from the seller at a predetermined future date for a predetermined price. Unlike options agreements where participation may be optional, both parties in a forward contract are obligated to complete the trade.

Forwards may trade on an exchange or over-the-counter (OTC) market. When a forward contract is traded on an exchange, it is known as a futures contract.

Key Characteristics and Differences

Forwards:

  • Customized contracts
  • Traded OTC
  • Counterparty risk is relatively higher

Futures:

  • Standardized contracts
  • Traded on exchanges
  • Counterparty risk mitigated by clearinghouses

Classification of Futures

Futures are typically classified into two categories based on the types of underlying assets:

1. Financial Futures

These contracts involve financial instruments as the underlying assets. Common types include:

  • Stocks
  • Bonds
  • Currencies
  • Interest Rates
  • Stock Indexes

2. Commodity Futures

These contracts involve physical commodities as the underlying assets. Common examples include:

  • Precious and Base Metals
  • Crude Oil and Natural Gas
  • Grains and Oilseeds
  • Meats and Dairy
  • Lumber

Forward Agreements

When a forward contract is traded over the counter, it is generally termed as a forward agreement. The most prevalent types of forward agreements typically involve currencies and interest rates.

Glossary

Forward Contract: A private, customizable agreement to buy or sell an asset at a specified future date for a price determined today.

Futures Contract: A standardized agreement traded on an exchange to buy or sell a specific amount of a commodity or financial instrument at a set price on a certain date in the future.

OTC (Over-the-Counter): A decentralized market where trading is done directly between two parties, without the oversight of an exchange.

Clearinghouse: An intermediary between buyers and sellers of financial instruments, ensuring the trade goes smoothly and mitigating the risk of default. :::

FAQs

Q: What is the primary difference between a forward and a futures contract?

A: The primary difference is that forwards are customized contracts traded OTC, whereas futures are standardized contracts traded on exchanges.

Q: What types of assets can be underlying in financial futures?

A: Common underlying assets in financial futures include stocks, bonds, currencies, interest rates, and stock indexes.

Q: Why are forward agreements typically used in interest rates and currencies?

A: Forwards are preferred for interest rates and currencies as they offer customization suitable for hedging specific financial exposures.

Key Takeaways

Key Takeaways

  1. Forward Contracts:

    • Customizable agreements tailored to specific needs.
    • Carry higher counterparty risk compared to futures contracts, which are standardized and traded on exchanges.
  2. Futures Contracts:

    • Classified based on their underlying assets into:
      • Financial Futures: Contracts based on financial instruments like interest rates, currencies, or indices.
      • Commodity Futures: Contracts based on physical commodities like oil, grains, or metals.
  3. Forward Agreements:

    • Particularly used for managing interest rates and currency risks.
    • Allow flexibility in customization to hedge specific financial risks effectively.

Futures Market Structure

    graph TD;
	    A[Trader] -->|buys contract| E[Exchange]
	    B[Trader] -->|sells contract| E
	    E -->|manages| C[Clearinghouse]
	    C --> D[Settlement]

The diagram above illustrates the structure of a futures market where the exchange trades contracts, and the clearinghouse manages and ensures settlement.

Comparison Table: Forwards vs Futures

Criteria Forwards Futures
Trading Venue OTC Exchange
Customization High (customized) Low (standardized)
Counterparty Risk Higher Lower (use of clearinghouse)
Liquidity Generally lower Generally higher
Common Use Interest rates, currencies Diverse including financials and commodities


CSC® Exams Practice Questions

📚✨ CSC Exam Questions ✨📚

Welcome to the Knowledge Checkpoint! You'll find 10 carefully curated CSC exam practice questions designed to reinforce the key concepts covered. These questions will help you gauge your grasp of the material, identify areas that need further review, and ensure you're on the right track towards mastering the content for the Canadian Securities certification exams. Take your time, think critically, and use these quizzes as a tool to enhance your learning journey. 📘✨

Good luck!

## What is a forward contract? - [ ] A contract allowing the buyer to choose when to complete the transaction - [ ] A contract that involves no obligations for both parties - [x] A contract between two parties to buy/sell an underlying asset at a future date at a pre-agreed price - [ ] A contract traded only on exchanges > **Explanation:** A forward contract is an agreement between two parties to buy or sell an underlying asset at a specific future date for a price agreed upon today. Both parties are obligated to complete the trade. ## Where can forwards be traded? - [ ] Only on exchanges - [x] On exchanges or OTC markets - [ ] Only in OTC markets - [ ] Only through brokerage firms > **Explanation:** Forwards can be traded on an exchange, where they are called futures, or in OTC (over-the-counter) markets. ## What is the key difference between forwards and futures? - [ ] Futures are traded OTC, while forwards are traded on exchanges - [x] Forwards are customized contracts that can trade OTC, while futures are standardized and traded on exchanges - [ ] Forwards are exempt from regulation, whereas futures are heavily regulated - [ ] Forwards don't include any obligations for the parties involved, unlike futures > **Explanation:** Forwards are customizable contracts that can be traded over-the-counter, while futures are standardized contracts that trade on exchanges. ## Which of the following is classified as a financial futures contract? - [ ] Crude oil - [ ] Corn - [x] Stock Index - [ ] Lumber > **Explanation:** Financial futures contracts have a financial asset as the underlying asset. Common examples include stocks, bonds, currencies, interest rates, and stock indexes. ## Which underlying asset might you find in a commodity futures contract? - [x] Grains - [ ] Currencies - [ ] Stocks - [ ] Stock Indexes > **Explanation:** Commodity futures contracts have a physical asset as the underlying asset. Examples include precious and base metals, crude oil and natural gas, grains and oilseeds, meats and dairy, and lumber. ## What type of agreement is a forward contract typically referred to as when traded over-the-counter? - [ ] Option - [ ] Swap - [ ] Future - [x] Forward agreement > **Explanation:** When a forward contract is traded over-the-counter, it is generally referred to as a forward agreement. ## Which market participants commonly utilize currency forward contracts? - [x] Businesses engaging in international trade - [ ] Individuals conducting day trading - [ ] Stock investors - [ ] Real estate investors > **Explanation:** Businesses engaging in international trade commonly use currency forward contracts to hedge against currency risk. ## What kind of obligation do both parties have in a forward contract? - [ ] Only the buyer is obligated - [ ] Only the seller is obligated - [x] Both parties are obligated to participate in the future trade - [ ] Neither party is obligated > **Explanation:** Both parties are obligated to participate in the future trade as specified in a forward contract. ## In what type of futures might you find cattle or milk as the underlying assets? - [ ] Financial futures - [x] Commodity futures - [ ] Forward agreements - [ ] Currency futures > **Explanation:** Commodity futures include contracts with physical assets as the underlying asset, such as meats and dairy. ## What is a predominant type of forward agreement? - [x] Interest rate forward - [ ] Stock index forward - [ ] Equity option - [ ] Real estate forward > **Explanation:** The predominant types of forward agreements are based on interest rates and currencies.

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In this section

  • 10.6.1 Key Terms And Definitions
    Comprehensive guide on key terms and definitions in futures contracts, including concepts of margin requirements, marking to market, and cash-settled futures within the context of the Canadian Securities Course.
  • 10.6.2 Futures Trading And Leverage
    Comprehensive guide on Futures Trading and Leverage including margin requirements, leverage effects, and safety considerations in futures trading.
  • 10.6.3 Futures Exchange
    This chapter provides a detailed overview of the Montréal Exchange, including the listing of index futures, Government of Canada bonds, bankers’ acceptances, and the 30-day overnight repo rate.
  • 10.6.4 Futures Strategies For Investors
    Explore key futures strategies for investors including speculative strategies and risk management techniques. Understand the benefits and risks associated with buying and selling futures.
  • 10.6.5 Futures Strategies For Corporations
    Understand how corporations utilize futures to manage risks, gain insights on practical examples, and discern differences and similarities between forward and futures contracts.
Sunday, July 21, 2024