Fundamentals of Financial Instruments, 2nd Edition

CHAPTER 6Forward and Futures Contracts

INTRODUCTION

In order to understand forward and futures contracts, let us commence our discussion with an illustration of a spot transaction. Assume that we are standing on 15 May 20XX and that we wish to buy 100 shares of ABC. We will go to an exchange like the NYSE and place a buy order for 100 shares of ABC stock. The order will be matched with a sell order placed by another party, assuming that a suitable counterparty is available, and a trade will be executed for 100 shares. Such a transaction is termed as a cash or a spot transaction. This is because as soon as a deal is struck between the buyer and the seller, the buyer has to immediately make arrangements for the cash to be transferred to the seller, while the seller has to ensure that the right to the asset in question, in this case shares of ABC, is immediately transferred to the buyer.

Now consider a slightly different situation. Assume that on 15 May 20XX we wish to enter into a contract to acquire 100 shares of ABC on 15 August 20XX, and that a counterparty exists who is willing to sell the shares on that day. If so, we can enter into a contract that entails the payment of cash on 15 August against delivery of shares on the same day. The difference as compared to the earlier transaction is that no money need be paid by the buyer at the time of negotiating the contract, and neither does the seller need to transfer rights to the underlying asset on that day. The actual exchange ...