future / forward contract
- Thread starter liordp
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Hi Convexity,
Hull gives two reasons, however (as i say in the tutorials) I really only ever encounter one of his reasons: the futures contract is marked-to-market daily and this (i) creates a more volatile contract price relative to the equivalent forward contract (more volatile = slightly more risky) and, more importantly, (ii) assuming an exchange-traded future with a margin account, this implies cash flow volatility: either a margin call (cash flow out of pocket) or excess margin that can be withdrawn (cash flow into pocket).
So the futures contract implies a bit of cash flow volatility "at the margin." So IMO the essential focused difference is: daily settlement (futures are; forward aren't)
Hull points out the cash flows are invested asymmetrically in the case of a Eurodollar futures contract (i.e., as rates go higher, margin account is flush and the extra cash is invested at a higher rate; as rates go lower, the margin call is funded at lower rates). Such that the futures price > forward price due the advantage of M2M...
...and this is consistent with the Eurodollar futures rate >> forward rate. In the case of the Eurodollar futures rate, I find it easier to just think "the futures is riskier so the rate must be higher."
FWIW, brief video here @ http://www.bionicturtle.com/learn/article/convexity_adjustment_for_eurodollar_futures_and_fra_5_min_screencast/
Hope that
Hull gives two reasons, however (as i say in the tutorials) I really only ever encounter one of his reasons: the futures contract is marked-to-market daily and this (i) creates a more volatile contract price relative to the equivalent forward contract (more volatile = slightly more risky) and, more importantly, (ii) assuming an exchange-traded future with a margin account, this implies cash flow volatility: either a margin call (cash flow out of pocket) or excess margin that can be withdrawn (cash flow into pocket).
So the futures contract implies a bit of cash flow volatility "at the margin." So IMO the essential focused difference is: daily settlement (futures are; forward aren't)
Hull points out the cash flows are invested asymmetrically in the case of a Eurodollar futures contract (i.e., as rates go higher, margin account is flush and the extra cash is invested at a higher rate; as rates go lower, the margin call is funded at lower rates). Such that the futures price > forward price due the advantage of M2M...
...and this is consistent with the Eurodollar futures rate >> forward rate. In the case of the Eurodollar futures rate, I find it easier to just think "the futures is riskier so the rate must be higher."
FWIW, brief video here @ http://www.bionicturtle.com/learn/article/convexity_adjustment_for_eurodollar_futures_and_fra_5_min_screencast/
Hope that
Hi Convexity - sure thing. Exotics are level 2; you maybe thinking of option strategies (e.g., straddle) which are level 1. Basically, combining vanilla calls/puts into strategies is level 1. Then, L2 is about non-plain-vanilla options. Thanks, David
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Hi David,
I´ve another question regarding the price divergence between forwards and futures prices. Margin calls are an instrument for mitigating counterparty risk. Does that not affect the futures price?
Best regards
I´ve another question regarding the price divergence between forwards and futures prices. Margin calls are an instrument for mitigating counterparty risk. Does that not affect the futures price?
Best regards
Hi Maddin,
Yes, Hull covers this in interest rate futures vs forwards. It's called convexity bias. The margin calls create cash additional interim cash flows (outflow or inflows in the case of excess margin returned) where that (i) adds a bit of risk vis à vis the forward and (ii) is a good/bad thing depending on interest rates (reinvestment risk). So the divergence becomes a function of the correlation between interest rates and the futures price (or spot price).
Thanks, David
Yes, Hull covers this in interest rate futures vs forwards. It's called convexity bias. The margin calls create cash additional interim cash flows (outflow or inflows in the case of excess margin returned) where that (i) adds a bit of risk vis à vis the forward and (ii) is a good/bad thing depending on interest rates (reinvestment risk). So the divergence becomes a function of the correlation between interest rates and the futures price (or spot price).
Thanks, David
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