3. Forward Commitments
b. contrast forward commitments with contingent claims;
c. define forward contracts, futures contracts, options (calls and puts), swaps, and credit derivatives and compare their basic characteristics;
What is a forward commitment?
A forward commitment is an agreement between two parties in which one party agrees to buy and the other agrees to sell an asset at a future date at a price agreed on today. In essence, a forward commitment represents a commitment to buy or sell.
What are the three types of forward commitments?
1. Forward contract
2. Futures contract
What is a forward contract?
A forward contract is a forward commitment created in the over-the-counter market. It is not conditional; both the buyer and the seller are obliged to perform the contract as agreed.
What is the difference between a forward contract and a spot contract?
- A forward contract is settled in the future.
- A spot contract is settled immediately
What is a futures contract?
A futures contract is almost identical to a forward contract except that is is traded on an official organized exchange.
What role does the clearinghouse play on futures contracts?
Performance on a futures contract is guaranteed by a clearinghouse - a financial institution associated with the futures exchange that guarantees the financial integrity of the market to all traders.
What is daily settlement or marking to market?
- Every day, the gain and loss incurred by each trader is computed based on the market price of the futures contracts.
- After the contracts are marked-to-market, funds are transferred from the traders who have sustained losses to traders who have incurred gains.
What is a swap?
A swap is a variation of a forward contract that is essentially equivalent to a series of forward contracts. Specifically, a swap is an agreement between two parties to exchange a series of future cash flows.