FINM7006 Chap.9 Forwards and Futures
Forwards and Futures
Forwards and futures create linear price exposure. A future buyer can go long to offset a price rise, while a future seller can go short to offset a fall. This chapter derives long and short payoffs, combines the derivative with the physical transaction and then separates forwards from exchange-traded futures through standardisation, margin and daily settlement.
Quantity, underlying, location and date determine whether the apparent price lock leaves basis risk.
What this chapter covers
- 01
Long and short forward obligations
- 02
Delivery price and maturity payoff
- 03
Commercial hedge direction
- 04
No-arbitrage forward pricing
- 05
Futures margin and daily settlement
- 06
Basis, quantity and timing risk
Worked example · free
Lock a future input purchase
- +1Physical purchase: 50,000($2.75) = $137,500.
- +2Forward gain: 50,000($2.75 - $2.40) = $17,500.
- +1Net cost: $137,500 - $17,500 = $120,000.
- +1Interpret: net price is $2.40 per unit because contract and purchase match.
Key terms
- Forward price
- Forward price is the delivery price that gives a new forward contract its agreed starting value.
- Long hedge
- A long hedge uses a long derivative position to offset harm from a future price rise.
- Short hedge
- A short hedge uses a short derivative position to offset harm from a future price fall.
- Basis risk
- Basis risk is the residual uncertainty created when spot and hedge-contract prices do not move identically.
Forwards and Futures FAQ
Why can a successful hedge show a derivative loss?
The underlying commercial position should benefit in the state where the hedge contract loses. A future buyer's long forward loses when spot falls, but the physical input becomes cheaper. Judge the combined exposure against the objective, not the derivative leg in isolation. The purpose may be certainty rather than outperformance.
How do I choose long or short direction?
Identify the price move that harms the unhedged business. A future buyer is harmed by a rise and takes a long position that gains when prices rise. A future seller is harmed by a fall and takes a short position that gains when prices fall. Write the exposure first, then the offset.
What makes futures different from forwards?
Futures are standardised, exchange-traded and marked to market through margin, so gains and losses arrive during the contract's life. Forwards are tailored bilateral agreements that usually settle at maturity. Similar terminal payoff logic can therefore hide different liquidity, counterparty and basis consequences.
Exam move
Draw the long forward payoff and obtain the short by reversing its sign. Pair each payoff with a physical purchase or sale and verify that the adverse movement offsets. Then practise quantity matching from exposure size and contract size. Add one sentence on residual basis, timing or liquidity risk. Compare forward and futures settlement without treating them as synonyms.
Finish with a no-arbitrage price that links spot and financing under stated assumptions. Start each hedge problem with a sentence that describes the physical exposure without naming a derivative. A future buyer loses when the price rises; a future seller loses when the price falls. Select the forward direction only after that adverse movement is clear.
Draw two separate payoff lines for the commercial transaction and derivative, using the same future spot price on the horizontal axis. Add the legs to reveal the effective locked price and explain that favourable as well as adverse movement is surrendered. For contract sizing, divide the exposure quantity by the units represented by one contract and discuss any rounding or residual exposure.
Match the delivery date to the commercial date and the underlying to the item being hedged. If either match is imperfect, name timing or basis risk. Create a comparison table for forwards and futures covering customisation, trading venue, daily settlement, margin, liquidity and counterparty exposure.
Do not reduce the distinction to one being private and the other public; explain how daily marking to market creates interim cash-flow needs. Work a simple futures variation-margin path so that gains and losses across days sum to the total price move while cash arrives at different times. For a no-arbitrage forward price, construct the cash-and-carry strategy from spot purchase and financing under the assumptions provided.
Treat the formula as a relationship that depends on carrying costs, income and market access, not as a forecast of the future spot price. In final revision, alternate a hedge-direction scenario, a payoff calculation, a contract-number problem and a pricing relationship. Require every answer to state the exposure, derivative direction, offset and remaining risk.
A hedge recommendation is incomplete if it gives only long or short without explaining what physical loss that position is intended to counter.
Working through Forwards and Futures in FINM7006? Sia is AskSia’s AI Finance tutor — ask any FINM7006 Forwards and Futures question and get a clear, step-by-step explanation grounded in how FINM7006 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
