Explain what forwards, futures and swaps are
The idea
Forward commitments oblige both parties to transact at terms agreed today. A forward is a customised, over-the-counter agreement to buy or sell an asset at a set price on a set date, carrying counterparty credit risk. Futures are the exchange-traded, standardised version: a clearing house stands between the parties and positions are marked to market daily, which largely removes credit risk. A swap exchanges series of cash flows over time and can be viewed as a bundle of forward contracts.
A practice question
Which forward commitment is exchange-traded and standardised?
- A futures contract — correct
- A swapWhy not: Traded over the counter and negotiated bilaterally, though many are now centrally cleared.
- A forward contractWhy not: The bilateral, customised version. Standardisation and an exchange listing are what turn it into a future.
Forwards and most swaps are customised over-the-counter agreements; futures are the standardised, exchange-traded form.
A harder one
Compared with a futures contract, a forward contract typically offers:
- standardised terms and lower counterparty riskWhy not: Describes the future on both counts, and forwards are the opposite on both.
- customised terms and lower counterparty riskWhy not: Right on customisation, wrong on credit: with no clearing house, exposure builds until settlement.
- customised terms but greater counterparty risk — correct
Bilateral negotiation buys a contract that fits the exposure exactly, at the cost of relying on the counterparty to perform.
The hardest tier
A corporate treasurer needs to hedge an exposure of an unusual size on a non-standard date. They would most likely use:
- an exchange-traded futures contractWhy not: Standardised in size and date, which is exactly what this exposure does not match.
- a listed optionWhy not: Also standardised, and it supplies a right rather than the fixed hedge described.
- a forward contract — correct
Standardised contracts leave residual basis risk when size and date do not match. Customisation is exactly what over-the-counter forwards are for.
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