Sep 02

Difference between forward price and futures price – 6 min screencast

by David Harper, CFA, FRM, CIPM

The key risks differ for a forward and futures contract:

As the forward is an OTC agreement, the key risk is counterparty risk; i.e., the risk the counterparty will default.
As the future trades on an exchange (as a counterparty, the exchange is highly unlikely to default) according to standardized terms, the key risk is basis risk; i.e., the standardized features will not provide a well-fitting hedge.

Why would the prices differ? According to Hull (5.8), the key difference is the daily settlement of the futures contract. The investor in a futures contract must maintain a margin account. The deciding factor is the correlation between the spot price and the interest rate. If the correlation (spot, interest rate) is strongly positive,

An increase in the spot implies an increase in the forward/futures value (recall delta equals approximately 1.0 for both). But only the futures contract is settled daily. In this case, an increase in value implies excess margin; the excess margin can be withdrawn from the margin account and (owing to the positive correlation) invested at a higher interest rate.
However, an decrease in the spot implies an decrease in the forward/futures contract value Here, an drop in contract value eventually implies a margin call; however, the margin call will be financed at a lower interest rate (owing again to the positive correlation). The scenarios are not symmetrical; on balance, the investor in a futures favors daily settlement—“the bird in the hand".

Screencast: