Forwards, Futures and Swaps

Forward Contracts

A forward contract is not an option. Both the buyer and the seller are obligated to perform under the terms of the contract.

They agree the terms of the contract today but exchange the asset and money at the agreed day in the future.

Futures Contracts

Instead of one large future we split it into lots of smaller standardized contracts that can be traded. So you can sell your obligation.

The broker will underwrite the transactions and this whole process reduces counter party risk.

Swaps

Swaps are arrangements between two counterparts to exchange cash flows over time.

Swaps are traded at OTC markets, usually involving an intermediary in the middle to arrange the deal and to reduce default risk.

Interest Rate Swaps

We establish a fixed rate obligation with a bank in return for them covering a variable rate obligation with another lender. So, we get the bank to cover our variable debt and pay them a fixed rate to do so.

Forwards vs Futures

A futures seller can choose to deliver of underlying asset on any day during the delivery term: either before or at the delivery. In forward contracts, assets are delivered only at the delivery date.

Futures contracts are traded on an exchange, whereas forward contracts are generally on over the counter (OTC) markets.

Real life Examples

Forward - Oil contracts where prices are locked in advance

Future - A bread manufacturer might buy wheat futures to hedge against the risk of rising wheat prices.