Market Risk Analysis Volume III: Pricing, Hedging and Trading Financial Instruments

III.2

Futures and Forwards

III.2.1 INTRODUCTION

A futures contract is an agreement to buy an underlying asset (or an interest rate) at a fixed date in the future, called the contract's expiry date, at a price agreed now. Futures are exchange traded contracts, so they have virtually no credit risk, and bid and ask market prices for a futures contract are quoted by market makers every few seconds throughout the trading day.¹ The buyer pays only a fraction of the contract price – the margin – and this is rebalanced daily as the futures price changes. At the time of expiry the futures price is equal to the spot price.²

The vast majority of futures contracts are on notional bonds such as the 2-, 5-, 10-year and long bond futures. Most of these are in the US, Europe and Japan. There are also some heavily traded futures contracts on money market interest rates, such as the 3-month eurodollar, eurosterling and EURIBOR contracts. The Bank for International Settlements (BIS) estimates that in June 2007 the notional size of the global bond and interest rate futures market was over $30 trillion. The BIS estimates for other futures contracts in December 2006 were: over $3 trillion on commodities; over $1 trillion on stock index futures; $200 billion on foreign exchange rates; and only a small amount in single stock futures. The total global turnover of futures contracts during 2006 was over $1,250 billion.³

A forward contract is essentially the same as a futures contract except that it is traded ...