9.2 Forwards, Futures, and Swap Basics
Key Takeaways
- Forwards and futures create similar economic exposure but differ in standardization, clearing, settlement, and counterparty risk.
- A long forward or futures position benefits when the underlying price rises above the contract price.
- Futures use margin accounts and daily settlement, which changes cash flow timing and reduces credit exposure.
- A swap is a series of forward-like exchanges, often used to transform interest rate, currency, or commodity exposure.
- The notional amount sets the scale of many derivative cash flows but is usually not exchanged in a plain interest rate swap.
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 long agrees to buy. The short agrees to sell. At expiration, the long gains when the spot price is above the forward price and loses when the spot price is below it.
The expiration payoff to a long forward is approximately spot price at expiration minus forward price. The payoff to the short is the opposite. This symmetry is important. For every gain on one side, there is an equal loss on the other side, before transaction costs and credit losses.
Forwards are usually OTC contracts. They can match the exact date, amount, currency, quality, and settlement terms needed by the parties. The weakness is counterparty risk. If the contract has become valuable to one side, the other side may fail to perform.
Futures contracts
A futures contract is a standardized forward commitment traded on an exchange. The exchange specifies contract size, underlying quality, delivery or cash settlement rules, expiration months, and trading procedures. A clearinghouse becomes the buyer to every seller and the seller to every buyer.
Futures positions are marked to market daily. Gains and losses are credited or debited through margin accounts as prices change. Initial margin is posted to open a position. Maintenance margin is the minimum balance that must be maintained. A margin call requires the trader to add funds when the balance falls too low.
Daily settlement reduces accumulated credit exposure. A losing trader pays losses as they occur rather than waiting until expiration. This does not remove market risk, but it makes default less likely to build silently over the life of the contract.
Forward versus futures comparison
| Feature | Forward | Futures |
|---|---|---|
| Trading venue | OTC | Exchange |
| Terms | Customized | Standardized |
| Counterparty risk | Bilateral and higher | Reduced by clearinghouse |
| Settlement | Usually at maturity | Daily marking to market |
| Liquidity | Contract specific | Often higher for active contracts |
| Upfront payment | Usually none | Margin required |
The two contracts can create similar directional exposure. A wheat farmer shorting wheat futures and a wheat farmer entering a short forward both benefit from locking in a future selling price. The futures version introduces daily cash flows from marking to market.
Swap basics
A swap is an agreement to exchange a series of cash flows over time. A plain vanilla interest rate swap often has one party pay a fixed rate and receive a floating rate on a notional amount. The other party receives fixed and pays floating. The notional is used to calculate payments, but it usually is not exchanged.
A borrower with floating-rate debt can enter a pay-fixed, receive-floating interest rate swap to synthetically create fixed-rate exposure. The floating receipts from the swap help offset floating interest payments on the debt. The borrower is left with a more predictable fixed payment profile.
Currency swaps can exchange interest and principal payments in different currencies. Commodity swaps can exchange fixed commodity prices for floating market prices. Equity swaps can exchange equity index returns for a fixed or floating rate. The shared idea is that parties exchange cash flow patterns to change risk exposure.
Structured aid: position payoff map
| Position | Main benefit | Main risk |
|---|---|---|
| Long forward or futures | Underlying price rises | Underlying price falls |
| Short forward or futures | Underlying price falls | Underlying price rises |
| Pay-fixed interest rate swap | Floating rates rise | Floating rates fall |
| Receive-fixed interest rate swap | Floating rates fall | Floating rates rise |
| Commodity producer short hedge | Commodity price falls | Lost upside if price rises |
| Commodity consumer long hedge | Commodity price rises | Lost benefit if price falls |
Exam focus
Start every problem by naming the long and short. If a contract price is 50 and the spot price at expiration is 57, the long forward payoff is 7 and the short payoff is -7. If the spot price is 44, the long payoff is -6 and the short payoff is 6.
For futures questions, watch for margin language. Initial margin opens the position. Maintenance margin triggers a margin call. Daily settlement means gains and losses are realized each day through the margin account.
For swaps, focus on the cash flow that offsets the risk. A company with floating-rate liabilities that fears rising rates usually wants to pay fixed and receive floating. A company with fixed-rate liabilities that wants floating exposure usually wants to receive fixed and pay floating.
A long forward contract with a forward price of 42 expires when the spot price is 47. The long position payoff is closest to:
The daily marking to market of futures contracts most directly reduces:
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: