6.2. HOW FUTURES CONTRACTS DIFFER FROM FORWARD MARKETS 227
Marking to market is the most crucial difference between forward and futures
contracts. It means that if an investor defaults, the “gain” from defaulting is simply
the avoidance of a one-day marking-to-market outflow: all previous losses have
already been settled in cash. This implies the following:
- Compared to a forward contract, the incentive to default on a futures contract
is smaller. By defaulting on the marking-to-market payment, one avoids only a
payment equal to that day’s price change. In contrast, in the case of a forward
contract, defaulting means that the investor saves the amount lost over the entire
life of the contract.
Example 6.6
Investor A boughteur1m atft 0 ,T =usd/eur0.96. By the last day of trading
but one, the futures price has drifted down to a level ofusd/eur0.89. So investor
A has already paid, cumulatively, 1m×(0.96 – 0.89) =usd70,000 as marking-to-
market cash flows. If, on the last day of trading, the price moves down by another
ten points, then, by defaulting, investor A avoids only the additional payment of
1m×0.001 =usd1,000. In contrast, if this had been a forward contract, the
savings from defaulting would have been the entire price drop between t 0 and T,
that is, 1m×(Ft 0 ,T–ST) = 1m×(0.96 – 0.889) =usd71,000. - From the point of view of the clearing house, the counterpart of the above state-
ment is that if an investor nevertheless fails to make the required margin payment,
the loss to the clearing house is simply the day’s price change.
In practice, the savings from defaulting on a futures contract (and the clearing
house’s loss if there is default) are even smaller than the above statement suggests
because of a second characteristic of futures markets—the margin requirements.
6.2.2 Margin Requirements
To reduce even the incentive of evading today’s losses, the buyer or seller also has to
put up initial security that almost surely covers a one-day loss. This is true security
in the sense that one earns interest on it.^1 The general idea behind the margin
requirements is that the margin paid should cover virtually all of the one-day risk.
This, of course, further reduces both one’s incentive to default as well as the loss to
the clearing house if there is default.
Margin also means limit, or line. In that sense, two margins have to be watched
when trading in futures markets,initial marginandmaintenance margin. Indeed, in
(^1) The marking-to-market payments are often called margin payments. This term is a bit mislead-
ing if “paying margin” is interpreted as “posting additional security”: if the payments really were
security, the payer would still be entitled to the normal interest on the money put up. In reality
there are no interest payments on the m-to-m payments, so economically these are final payments
not security postings—unlike the initial margin, which is genuine security.