Chapter 6

The Structure of Forward

and Futures Markets

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 Forward Contract

• Is an agreement between two parties, a buyer and a

seller, that calls for delivery of an asset at a future
point in the time with a price agreed upon today.

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• Forward contract, sometimes called forward
commitments, are very common in everyday life. For
example, an apartment lease is a series of forward
contract. The current month's use of the apartment is a
spot transaction, but the two parties also have agreed to
usage of the apartment for five months at a rate agreed
upon today.
• Also any type of contractual arrangement calling for
the delivery of a good or service at future date at a
price agreed upon today is a forward contract. 3
 Futures Contract

• Is a forward contract that has standardized terms, is

traded on an organized exchange, and follows a daily
settlement procedure in which the losses of one party
to the contract are paid to the other party.

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Over-The-Counter Forward Market Advantage
• The forward market is large and worldwide. The two
parties to a forward contract must agree to do business
with each other, which means that each party accepts
credit risk from the other.
1- The terms and conditions are tailored to the specific
needs of the two parties.
2- It is a private market in which the general public dose not
know that the transaction was done. This prevents other
traders from interpreting the size of various trades as
perhaps false signals of information.(like option)
3-An unregulated market. 5
 Organized Futures Trading
• Futures trading is organized around the concept of a
futures exchange. The exchange is the most important
component of a futures market and distinguishes it
from forward markets.

• A futures exchange is a corporate entity comprised of

members. The members elect a board of directors.
The exchange has a corporate hierarchy consisting of
officers, employees, and committees.

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 Contract Terms and Conditions
• The contract's terms and conditions are determined by
the exchange subject to regulatory approval.
• The specifications for each contract are the size,
quotation unit, minimum price fluctuation, grade,
trading hours and delivery terms and daily price limits.

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 Forward Contract Futures Contract

Definition A forward contract is an A futures contract is a

agreement between two standardized contract,
parties to buy or sell an asset traded on a futures
(which can be of any kind) exchange, to buy or sell
at a pre-agreed future point a certain underlying
in time at a specified price. instrument at a certain
date in the future, at a
specified price.
Structure & Customized to customer Standardized. Initial
Purpose needs. Usually no initial margin payment
payment required. Usually required. Usually used
used for hedging. for speculation.
Transaction Negotiated directly by the Quoted and traded on
method buyer and seller the Exchange

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Market regulation Not regulated Government regulated
market (the Commodity
Futures Trading
Commission or CFTC is
the governing body)
Institutional The contracting parties Clearing House takes the
guarantee responsibility of defaults
and pay to the other party
Both parties have direct Parties have indirect
contract between them, and contracts between them, as
payments are also handled exchange write a contract
by them independently as in between both parties. 
per there own terms and The exchange collect the
conditions. payment from one party
and transfer to other party
Trading Trades at over the counter Trades at future exchange
exchange

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Risk Rare default risk exist No default risk
Guarantees No guarantee of settlement Both parties must deposit
until the date of maturity an initial guarantee
only the forward price, (margin). The value of the
based on the spot price of operation is marked to
the underlying asset is paid market rates with daily
settlement of profits and
losses.
Contract Forward contracts Future contracts may not
Maturity generally mature by necessarily mature by
delivering the commodity. delivery of commodity.
Expiry date Depending on the Standardized
transaction
Contract size Depending on the Standardized
transaction and the
requirements of the
contracting parties.

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Liquidity Since forward markets are Futures markets offer the
intended to be in force till parties liquidity, which
maturity, so they don’t gives them a means of
provide liquidity. buying and selling the
contracts.  Because of this
liquidity, a party can enter
into a contract and later,
before the contract
expires, enter into the
opposite transaction and
offset the position, and
then reverse the
transaction later.

Market Primary Primary & Secondary

Traded privately Publically traded

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• Forward contracts are very similar to future contracts.

• Future contract is a series of forward contracts.

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 Future Contact Terms and Conditions
• The contract’s terms and conditions are determined
by the exchange subject to regulatory approval. The
specifications for each contract are:

1- Contract size means that one contract covers a specific

number of units of the underlying asset.
2- Quotation unit is simply the unit in which the price is
specified.

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3- Minimum price fluctuation , closely related to the
quotation unit. Usually the smallest unit of quotation.

4 - Contract grade (different quality price).

5 - Trading hours. Most financial futures trade for about
six hours and electronic trading occurs at night when
floor trading not open.
6 - Delivery terms indicate delivery date or dates, the
delivery procedure, and a set of expiration months.

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7- Daily price limits. During trading day prices fluctuate,
many contracts have limits on the daily price change. If
a contract price hits the upper limit, the market is said
to be limit up. If the price move to the lower limit, the
market is said to be limit down. Any such move up or
down is called a limit move. Normally no transactions
above or below the limit price are allowed.

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 General Classes of Futures Traders
All traders on the futures exchange are either commission
brokers or locals.
1- the brokerage firms are called futures commission
merchants(FCM), simply executes trades for the FCM’s
customers. Commission brokers make their money by
charging a commission for each trader.
2- Locals are individuals in business for themselves who
trade from their own accounts.
3- Dual trading in which the trade for themselves and
also trade as brokers for others.

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 Classification by Trading Strategy

• Buyers and sellers in the futures market

primarily enter into futures contracts to hedge
risk or speculate rather than to exchange
physical goods (which is the primary activity
of the cash/spot market).

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There are four types:
1- Hedgers,  protection against changing in prices.
2- Speculators attempt to profit from guessing the
direction of the market.
3- Spreaders use futures spreads to speculate at a low
level of risk.
4- Arbitrageurs attempt to profit from differences in
the price.
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 Classification by Trading Style

• Future traders can also be classified by the style of

trading they practice. There are three distinct trading
styles:
1- Scalpers attempt to profit from small changes in
the contract price. Scalpers seldom hold their
positions for more than a few minutes. They buying
from the public at the bid price and selling to the
public at the ask price. 19
 2- Day trader hold their position for no longer than
the duration of the trading day.

3- Position traders hold their transaction open for

much longer periods than do scalpers and day traders.
• A speculator may employ any or all of these
techniques in transactions.

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 Mechanics of Future Trading

• Before placing an order to trade future contract, an

individual must open an account with a broker.
Because the risk of future trading can be quite high,
the individual must make a minimum deposit-usually
at least $5,000 (initial margin).

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Mechanics of Future Trading

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• For each transaction, there is both a buyer, usually called
the long, and a seller typically called the short.
• In the absence of a clearinghouse, each party would be
responsible to the other. If one party defaulted, the other
would be left with a worthless claim.
• The clearinghouse assumer the role of intermediary to
each transaction. It guarantees the buyer that the seller
will perform and guarantees the seller that the buyer will
perform.
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• For each contract there is also a maintenance
margin, the amount that must be maintained every
day.
• At the end of each day, a committee composed of
clearinghouse officials establishes a settlement price.
This is an average of the price of the last few trades
of the day.
• The difference in the current settlement price and the
previous day's settlement price is determined.
-If the difference is positive because the settlement
price increased, the dollar amount is credited to the
margin accounts of those holding long positions.
Where dose the money come from? It is charged to
the accounts of those holding short positions. 24
 - If the difference is negative because the settlement price
decreased, , the dollar amount is credited to the margin
accounts of those holding short positions and charged to
those holding long position.
• This process, called the daily settlement, is an important
feature of futures markets and a major difference between
future and forward markets.
• In forward markets, the gains and losses are normally
incurred at the end of the contract’s life, when delivery is
made. futures markets credit and charge the price change on
a daily basis. 25
 Types of Future Contracts
1. Agricultural commodities.
2. Natural resources.
3. Miscellaneous commodities.
4. Foreign currencies.
5. Federal funds and Eurodollars.
6. Treasury notes and bonds.
7. Swap future.
8. Equities.
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What is the difference between an options
contract and a futures contract?

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