3.2. Pricing and Valuation of Futures ContractsWatch Video
Futures contracts have standard terms, are traded on a futures exchange, and are more heavily regulated than forward contracts. Some of its characteristics are listed below:
Marking to market: Futures contracts are marked to market on a daily basis. What this means is that if there is a gain or loss on the position relative to the previous day’s closing price, then the gain is credited to the winning account by deducting the amount from the losing account.
Credit guarantee: We saw that there was a default risk inherent in every forward contract. In futures contracts, there is a credit guarantee by the futures exchange through the clearinghouse.
Clearinghouse: The clearinghouse is the counterparty to every trade on the exchange.
Daily cash flow: In a forward contract, the gain or loss is realized at the end of the contract period. But, in a futures contract, there is a cash flow on a daily basis.
Relationship between futures prices and interest rates
If futures prices are positively correlated with interest rates, futures contracts are more desirable to holders of long positions than are forwards because there are intermediate cash flows on which interest can be earned. This cash flow can be invested at higher interest rates.
If interest rates are constant, or have zero correlation with futures prices, then forwards and futures prices will be the same.
If futures prices are negatively correlated with interest rates, then it is more desirable to have forwards than futures to holders of long positions.
Payoffs and Valuation of Futures Contracts
Let us take a simple example to compare the payoffs and valuation of a forward contract with a futures contract over three days. The futures price at the end of every day is given below with the price at initiation being 100.
Gain to Long in a Forward Contract
Ignoring the time value of money, total payoff is the same for forward and futures contract.
If the time value of money is considered, then it depends on the correlation of futures and interest rate.
Zero at initiation.
Keeps on increasing until expiration of contract.
Zero at initiation.
Keeps rising until settlement on the next trading day. Becomes zero once marked to market. For instance, increase from 0 to 1 on day 1.
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