6.2. HOW FUTURES CONTRACTS DIFFER FROM FORWARD MARKETS 225
6.2 How Futures Contracts Differ from Forward Markets
kets
A currency futures contract has the following key characteristics: (i) it has zero
initial value; (ii) it stipulates delivery of a known number of forex units on a known
future dateT; and (iii) thehcpayment for the forex is a known amountft,T, paid
later.
The only news here, relative to a forward contract, is the last word—the vague
term ”later” rather than the precise expression “atT”. In fact, we can be more
specific about the timing of the payments: of the total, which isft,T, the part
ft,T−S ̃Tis paid gradually during the life of the contract via daily marking-to-market
payments, and the remainder,S ̃T, is paid at maturity. Note that the pattern of the
payments over time is ex ante unknown: we only know the grand total that we will
pay, the no-time-value-correction sum.
We show how this marking-to-market system is a somewhat primitive version of
the daily-recontracting system we discussed in the previous section. So it is a way
to mitigate the problem of default risk. Given that this problem is largely solved,
futures contracts can be transferred among investors with minimal problems. We’ll
see how this is done: with standardized contracts, in organized markets, and with
the clearing corporation as the central counterpart. We’ll use the following jargon:
“buying a contract” means engaging in a purchase transaction—going long forex,
that is: you will get forex and payhc; and a futures price is per unit of currency,
even though the contract always is for a multiple offcunits.
6.2.1 Marking to Market
Recall that when a forward contract is recontracted every day, the buyer receives
a daily cash flow equal to thediscountedchange in the forward price. Thus, rising
prices mean cash inflows for the buyer, and falling prices mean cash outflows. (The
signs are reversed when the seller’s point of view is taken.) Also, as the interim
payments are based on the discounted forward price, the total amount paid is still
equivalent to paying the initially contracted rate,Ft 0 ,T, at the contract’s expiration
date.
A futures contract works quite similarly, except that the discounting is omitted.
So the daily payments are equal to the undiscounted changes in the futures prices.
The reasons for this simplifications were not hard to guess: it made sense at the
time futures were designed, the mid 1800s. (i) Futures contracts had short lives, and
interest rates were low (these were the days of the gold standard), so discounting
made no huge difference. (ii) Discounting means smaller payments; this is welcome
when the payment is an outflow (like in our Smitha example), but it’s bad news
when we face inflows. So if price rises are roughly equally probable as price falls,
on average it made no difference, people felt. And (iii), painfully, in the 1800s