Modern Portfolio Theory and Investment Analysis, 9th Edition

24

The Valuation and Uses of Financial Futures

Forward contracts are commitments entered into by two parties to exchange a specific amount of money for a particular good or service at a specified future time. Although the price is decided upon at the time of the agreement, no cash changes hands at that time. However, either or both parties to the transaction often have to post some funds to guarantee fulfillment of the contract. Forward contracts are a part of everyday life. When one orders a car not in stock from a dealer, one is buying a forward contract for the delivery of a car. The price and description of the car are specified. In this case the delivery date might not be exact. In addition, a deposit is often required to guarantee that the buyer will take delivery and pay the agreed-upon price.

In this chapter we will be primarily concerned with financial futures, though we will say a few words about other types of futures. Financial futures are similar to, but slightly different from, forward contracts. The name financial future is very descriptive. Financial means that the good to be delivered is a financial instrument (e.g., a stock or bond). The word future as opposed to forward reflects the fact that on these contracts, profits and losses are computed and settled on a day-to-day basis rather than at the end of the contract. This is called marking to the market, and we will have more to say about it shortly. In addition, contracts for financial futures are traded on organized ...