Actuarial Finance

3 Forwards and futures

In many situations, it is good risk management to fix today the price at which an asset will be purchased in the future. Here are two examples:

• Consider a company regularly buying gold as an input for its business, e.g. that company could transform gold to make jewelry. This company is clearly exposed to the (random) fluctuations of the gold price. More specifically, it would suffer from an increase in the price. In this case, it may be a good idea to enter into a financial agreement that fixes the price of gold today for delivery in the future. Therefore, the cost of jewelry made over the next few weeks/months can be known in advance.
• An insurance company based in the U.S. but also doing business in Canada is exposed to changes in the currency rate between the U.S. dollar (USD) and the Canadian dollar (CAD). It could enter into a financial agreement to fix today the exchange rate between these currencies that will apply in the future.

Forward contracts and futures contracts can be used specifically for this purpose: fix today the price of a good to be bought in the future. They are also commonly known as forwards and futures, without the word contract or agreement attached to them.

The role of this chapter is to provide an introduction to forwards and futures. The specific objectives are to:

• recognize situations where forward contracts and futures contracts can be used to manage risks;
• understand the difference between a forward contract and a futures ...