Forwards and Futures

A company that wants to fix a future purchase or sale price today may enter into a forward with a bank. A futures contract, which trades on an exchange, comes up in daily mark-to-market and margin management.

A forward is a promise made today to buy or sell in the future

A forward contract is a promise to buy or sell a specific asset on a set future date at a price agreed today¹. The asset being bought and sold is called the underlying asset, the agreed date is called maturity, and the agreed price is called the forward price. Forwards are one type of derivative, along with futures contracts, swaps, and options². How derivatives work in general is covered in What Is a Derivative?

Consider a hypothetical example in which Company A enters into a forward with Bank E to buy one unit of an underlying asset for 102 yen in one year. Company A is the buyer and Bank E is the seller. On the day they agree the trade, neither the asset nor any cash passes between them². In one year, whatever the price of the asset is, Company A pays 102 yen and receives the asset, and Bank E delivers the asset and receives 102 yen. Forwards on interest rates include the FRA (forward rate agreement), and trades that fix an exchange rate between currencies include the FX forward³⁴.

Profit or loss at maturity is proportional to the price difference

The buyer of a forward makes a profit if the price at maturity is above the forward price and a loss if it is below; the seller's profit or loss is the reverse⁵. For the buyer, imagine buying the asset at the agreed price and selling it right away at the price at maturity; the difference is the profit or loss. For the seller, imagine buying the asset at the price at maturity to deliver it⁵. In the example above, the profit or loss per unit at each price at maturity is as follows.

The buyer's profit or loss is "price at maturity − 102 yen" and the seller's is "102 yen − price at maturity", so each 1-yen move in the price changes the profit or loss by 1 yen. The buyer's and the seller's profit or loss add up to zero at every price. The buyer's loss is at most 102 yen, reached when the price falls to zero. The seller's loss, on the other hand, has no upper limit.

Figure description

This is the buyer's profit or loss at maturity for a forward to buy one unit of an underlying asset for 102 yen in one year. The horizontal axis is the price of the underlying at maturity, and the vertical axis is the profit or loss per unit. The profit or loss is a straight line that rises by the same amount as the price. It is zero (the breakeven point) at a price of 102 yen, a profit above that, and a loss below it. At a price of 62 yen the loss is 40 yen, and at 142 yen the profit is 40 yen. The seller's profit or loss is this line flipped upside down around the zero line.

The forward price is the spot price plus the cost of carry

The forward price is set at the spot price plus the cost of holding the asset until maturity. Consider a hypothetical example in which the underlying asset costs 100 yen today, you can borrow for one year at 2% a year, and the asset pays no income such as interest. The funding cost is 100 × 2%, or 2 yen, so the forward price for one year is 100 + 2, or 102 yen, the same price as in the first example. If the asset pays 1 yen of interest over the year, the forward price is 100 + 2 − 1, or 101 yen.

To see why the price comes out at this level, consider a dealer who receives an order to deliver a government bond in one week. The dealer can buy the bond now and hold it for the week until delivery, then deliver it as promised. If the dealer sets the forward price at the purchase price plus the cost of funding the purchase, the dealer does not lose money. Any interest the dealer receives on the bond while holding it can be subtracted from that cost⁶.

$$\text{Forward price} = \text{Spot price} + \text{Funding cost} - \text{Income from holding}$$

This way of setting the price is called the cost of carry model⁶.

Using a forward to lock in the price of an asset you will buy later

One use of a forward is hedging: fixing today the price of an asset you plan to buy or sell in the future, to limit losses from price moves. Prices of stocks, bonds, and other assets change every day, so you cannot know today the price at which you will trade later. Hedging aims to reduce this uncertainty as much as possible⁷. Suppose Company A in the first example plans to buy the underlying asset in one year. If it fixes the price at 102 yen with a forward, it pays only 102 yen even if the price at maturity rises to 122 yen. That is 20 yen less than buying in the market, and the forward shows a profit of 20 yen. If, on the other hand, the price at maturity falls to 82 yen, Company A pays 102 yen for what it could have bought in the market for 82 yen, and the forward shows a loss of 20 yen. The company gives up the gain from a price fall in exchange for avoiding the loss from a price rise.

A forward is also used for speculation, which seeks profit from price moves. The difficulty of exiting early is a risk of using a forward.

A futures contract is a forward with standard terms

A futures contract is a forward that trades on an exchange, with terms standardized so that it can be closed out with an opposite trade before maturity¹. The exchange sets the standard terms to meet investors' needs. In JGB futures, for example, the underlying is not an issued government bond but a notional bond, which is a bond that does not actually exist, and delivery is set quarterly, in March, June, September, and December⁹. Ending a position with a trade opposite to the original one is called an offsetting trade. In futures, by the last trading day, a buyer closes out by reselling and a seller by buying back¹⁰.

Forwards and futures are the same in that both are agreements to buy or sell in the future. They differ in where they are traded and in the rules that come with that⁹. The table compares them on four points.

In futures, you trade through an exchange with many counterparties you do not know, so whether the other side will keep its promise becomes an issue. Open positions are therefore revalued at each day's closing price to calculate the profit or loss (mark-to-market). That profit or loss is settled, the position is treated as reopened at that price, and sufficient margin is required⁹. The collateral deposited for trading is called margin¹¹. How margin works is covered in Futures Margin and Daily Settlement.

Forwards have no mechanism for closing out with an offsetting trade on an exchange. Some derivative products that financial institutions enter into with customers cannot, as a rule, be canceled⁸. Exchange-traded derivatives, whose specifications the exchange sets, and OTC derivatives, whose terms the parties set, also differ in how collateral is exchanged and how to exit early.

Settlement at maturity is physical delivery or cash settlement

Settlement at maturity is either physical delivery, in which the underlying asset and cash are exchanged, or cash settlement, in which only the difference is paid. In physical delivery, the buyer pays the agreed price and receives the underlying asset⁵. In cash settlement, only the difference between the price at the time of the agreement and the price at settlement is paid¹².

For futures in Japan, the method of final settlement is set for each product. Nikkei 225 Futures, an equity index futures contract, is cash-settled because the index itself cannot be delivered¹³. Both 10-year JGB Futures and Gold Standard Futures are products in which the physical asset is delivered¹². The cash settlement of Nikkei 225 Futures is calculated with the special quotation (SQ).

Notes

1. Pension Fund Association, "先物取引（用語集）" (Glossary: futures trading, in Japanese). ↩ ↩²

2. Japan Exchange Group, "国債先物入門" (Introduction to JGB Futures, in Japanese), by Takahiro Hattori, 2021, section "2．1 先物はあくまで予約取引" (Futures are simply reservation trades), page 2. ↩ ↩²

3. Bank of Japan, "「デリバティブ取引に関する定例市場報告」の解説" (Explanation of the Regular Derivatives Market Statistics, in Japanese), 3(2) "リスク・ファクター別" (By risk factor), which lists FRAs as an example of interest rate contracts. ↩

4. Financial Futures Association of Japan, "金融先物取引の知識" (Knowledge of financial futures trading, in Japanese), 2015, the note to the ASX 24 table in "海外主要取引所の主要金融先物商品の概要" (Overview of major financial futures products on major overseas exchanges), page 51, which gives FRA as the abbreviation of Forward Rate Agreement. ↩

5. Central Council for Financial Services Information, "2-4 先物取引で発生する損益（やさしいデリバティブ）" (Profit and loss from futures trading, Easy Derivatives, in Japanese), "受渡決済とは" (What is delivery settlement?), "先物での買い手の損益" (The buyer's profit and loss in futures), and "先物での売り手の損益" (The seller's profit and loss in futures). ↩ ↩² ↩³

6. "国債先物入門" (Introduction to JGB Futures, in Japanese), "BOX 2 先渡（フォワード）価格のプライシング" (Pricing the forward price), pages 20–21. The document's formula is "先渡価格＝現物価格＋（レポ・コスト－利子収入）" (forward price = spot price + (repo cost − interest income), our translation). This page writes the repo cost as the funding cost and the interest income as the income from holding. ↩ ↩²

7. Central Council for Financial Services Information, "1-3 デリバティブの特徴と利用法（やさしいデリバティブ）" (Features and uses of derivatives, Easy Derivatives, in Japanese), "ヘッジング（hedging）" (Hedging). ↩

8. Financial Services Agency, "デリバティブ商品を契約するときのポイント" (Points to check when entering into a derivative product, in Japanese), "ルールと着眼点" (Rules and points of focus) and "説明事項（主な例）" (Items to be explained: main examples). ↩ ↩² ↩³

9. "国債先物入門" (Introduction to JGB Futures, in Japanese), section "2. 3 先渡（フォワード）との違い：先物の本質は取引所取引" (How futures differ from forwards: the essence of futures is exchange trading), pages 4–5. ↩ ↩² ↩³

10. Osaka Exchange, "決済方法（先物）" (Settlement methods (futures)), Kitahama Investment School (in Japanese), "反対売買による決済" (Settlement by offsetting trades). ↩

11. Japan Exchange Group, "先物取引（用語集）" (Glossary: futures trading, in Japanese). ↩

12. Osaka Exchange, "先物取引とは" (What is futures trading?), Kitahama Investment School (in Japanese), "差金の受け渡しで決済する" (Settling by paying the difference) and its note. ↩ ↩²

13. Osaka Exchange, "契約（取引成立）から満期まで（先物）" (From contract (execution) to expiration (futures)), Kitahama Investment School (in Japanese). ↩