The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

INTEREST RATE FUTURES AND FORWARD CONTRACTS

A futures contract is an agreement that requires a party to the agreement either to buy or sell something at a designated future date at a predetermined price. The buyer of a futures contract is said to be long the contract. The seller of a futures contract is said to be short the contract. The risk–return feature of futures contracts and the mechanics of trading them are covered in Chapter 14 and will not be repeated here. Instead, we focus on specific contract features, the special considerations in pricing them, and several portfolio applications.

Futures vs. Forward Contracts

A forward contract, just like a futures contract, is an agreement for the future delivery of something at a specified price at the end of a designated period of time. Futures contracts are standardized agreements as to the delivery date (or month) and quality of the deliverable, and are traded on organized exchanges. A forward contract differs in that it is usually nonstandardized (that is, the terms of each contract are negotiated individually between buyer and seller), there is no clearinghouse, and secondary markets are often nonexistent or extremely thin. Unlike a futures contract, which is an exchange traded product, a forward contract is an over-the-counter instrument.

Futures contracts are marked to market at the end of each trading day. Consequently, futures contracts are subject to interim cash flows as additional margin may be required in the ...