9.2 Forwards, Futures, and Swap Basics
Key Takeaways
- Forwards and futures create similar directional exposure but differ in standardization, clearing, settlement timing, and counterparty risk.
- A long forward or futures payoff at expiration equals spot minus the contract (forward/futures) price; the short payoff is the mirror image.
- Futures use initial and maintenance margin with daily mark-to-market; a margin call restores the balance to the initial margin level.
- A swap is a series of forward-like exchanges; a plain vanilla interest rate swap exchanges fixed for floating on a notional that is usually not exchanged.
- A forward rate agreement (FRA) is a forward on a future interest rate; its fixed rate is the no-arbitrage forward rate that gives zero initial value.
Forward contracts
A forward contract is a private agreement to buy or sell an underlying at a future date for a price set today (the forward price). The long agrees to buy; the short agrees to sell. At expiration the long gains when the spot price exceeds the forward price and loses when it is below.
The long's expiration payoff is spot at expiration minus forward price (S_T - F_0); the short's payoff is the opposite. This symmetry matters: every gain on one side is an equal loss on the other before transaction costs and credit losses. Forwards are usually OTC and can match the exact date, amount, currency, and grade the parties need. Their weakness is counterparty risk: once the contract has become valuable to one side, the other may default.
Futures contracts
A futures contract is a standardized, exchange-traded forward commitment. The exchange sets contract size, deliverable grade, delivery or cash-settlement rules, and expiration months, and a clearinghouse intermediates every trade. Futures are marked to market daily: gains and losses flow through margin accounts each day.
- Initial margin is the deposit required to open a position.
- Maintenance margin is the minimum balance allowed before a margin call.
- A margin call requires the trader to top the account back up to the initial margin level (the variation margin), not merely to the maintenance level.
Worked example: initial margin is 6 and maintenance margin is 4 per contract. If accumulated daily losses push the balance to 3.5 (below 4), the trader must deposit 2.5 to restore the balance to the initial margin of 6. Daily settlement reduces the silent buildup of credit exposure because losers pay as losses occur rather than at maturity.
Forward versus futures comparison
| Feature | Forward | Futures |
|---|---|---|
| Venue | OTC | Exchange |
| Terms | Customized | Standardized |
| Counterparty risk | Bilateral, higher | Reduced by clearinghouse |
| Settlement | Usually at maturity | Daily mark-to-market |
| Liquidity | Contract-specific | Often higher |
| Upfront cash | Usually none | Margin required |
The two create similar directional exposure. A wheat farmer shorting wheat futures and one entering a short forward both lock in a selling price; the futures version simply adds daily cash flows from marking to market and can introduce small valuation differences when interest rates correlate with futures prices.
Forward rate agreements (FRAs)
A forward rate agreement (FRA) is a forward contract on a future interest rate. The long pays a fixed rate and receives a floating reference rate (such as a market reference rate) on a notional for a stated future period. The fixed FRA rate is the implied forward rate from the current spot curve, set so the FRA has zero value at initiation. A borrower who fears rising short-term rates buys (goes long) an FRA: if the floating rate rises above the fixed rate, the FRA pays the long, offsetting the higher borrowing cost. FRAs are the building block that links forwards to the swap below.
Swap basics
A swap is an agreement to exchange a series of cash flows, economically a portfolio of forwards. A plain vanilla interest rate swap has one party pay fixed, receive floating and the other receive fixed, pay floating on a notional that is used only to size payments and is not exchanged. A borrower with floating-rate debt who fears rising rates enters a pay-fixed swap: the floating receipts offset the floating debt payments, leaving a predictable fixed net cost.
Currency swaps exchange interest and principal in different currencies (principal is exchanged here); commodity and equity swaps exchange fixed for floating prices or index returns.
Structured aid: position payoff map
| Position | Main benefit | Main risk |
|---|---|---|
| Long forward/futures | Underlying rises | Underlying falls |
| Short forward/futures | Underlying falls | Underlying rises |
| Pay-fixed swap / long FRA | Floating rates rise | Floating rates fall |
| Receive-fixed swap | Floating rates fall | Floating rates rise |
| Producer short hedge | Price falls | Lost upside if price rises |
| Consumer long hedge | Price rises | Lost benefit if price falls |
Settlement: delivery versus cash, and closing a position
Forward commitments can settle two ways. Physical (delivery) settlement transfers the actual underlying at maturity: the short delivers the asset and the long pays the contract price. Cash settlement exchanges only the net gain or loss, which is the standard for index futures, FRAs, and most swaps where physical delivery is impractical. Most futures traders never take delivery; they close out the position before expiration by entering an offsetting trade (a long who sells an identical contract, or a short who buys one), and the clearinghouse nets the two so only the price difference is realized.
This is why exchange-traded futures are so liquid relative to bespoke forwards: a standardized contract can be reversed against any other market participant, whereas an OTC forward can usually be unwound only with the original counterparty or by entering a new, offsetting bilateral contract that leaves credit exposure on both.
Exam focus
Name the long and short first. If the contract price is 50 and spot at expiration is 57, the long payoff is +7 and the short is -7; if spot is 44, the long is -6 and the short is +6. For futures, watch margin language: initial margin opens, maintenance triggers a call, and the call restores the initial level, not the maintenance level. For swaps and FRAs, find the cash flow that offsets the exposure: a floating-rate borrower fearing higher rates pays fixed and goes long the FRA.
A subtle distinction the exam likes is that the notional in a plain interest rate swap is never exchanged, whereas in a currency swap the principal usually is exchanged at both the start and the end, so do not assume notional always changes hands.
A long forward contract with a forward price of 42 expires when the spot price is 47. The long position payoff is closest to:
A futures account has an initial margin of 6 and a maintenance margin of 4 per contract. After daily losses the balance falls to 3.5. The trader's required deposit (variation margin) is closest to:
A borrower with floating-rate debt that wants to reduce exposure to rising short-term interest rates would most likely enter an interest rate swap to: