Futures vs. ForwardsMedium

The same economic bet, settled two entirely different ways. One pays you every evening; the other pays you once, at the end — and that difference has bankrupted people whose view was correct.

5 min read · 892 words

The same bet, and not the same contract

• Both agree a price today for delivery later. On the economics of the final outcome they are close to identical, which is why they are taught as one idea and traded as two.
• A forward is negotiated between two parties. Any size, any date, any underlying they both accept. Nothing moves until settlement.
• A future is a standardised contract on an exchange, cleared by a central counterparty, and settled in cash every single day.
• That last clause is the whole difference, and everything below follows from it.

What daily settlement actually does

• A future pays or collects every evening. The exchange marks the position to the settlement price and moves cash: gains are credited, losses are debited. By the next morning the contract is re-struck at the new price and nobody owes anybody anything from yesterday.
• A forward accumulates. Nothing moves until the end, at which point the whole difference is owed at once by whichever side lost.
• So the two positions have identical final outcomes and completely different cash-flow paths — and a position is held by somebody who has to fund it, not by an equation.
• The failure that only exists on the futures side: being right about the destination and unable to fund the path. Margin is due the day it is called, from a position that has not yet produced the gain that justifies it. Metallgesellschaft in 1993 is the recorded version, and LDI in 2022 is the same mechanism in a different market.
• The failure that only exists on the forward side: the counterparty is still there at the end. A forward is an unsecured exposure to one named firm that grows as the position moves in your favour — see if the other side fails.

Two kinds of margin, and only one is a deposit

• Initial margin is collateral against the move that could happen before a defaulting position is closed out. It is yours; it is returned. It is a deposit.
• Variation margin is not a deposit at all. It is the settlement of the day's loss — money that has left and is not coming back unless the market comes back. Calling both of them "margin" is the single most expensive vocabulary collapse in this subject.
• Nothing about a forward requires either, unless the two parties agreed a collateral schedule — and most institutional forwards now do, which narrows the gap without closing it. Margin and collateral covers the mechanism.

Why the two prices are not identical

• Daily settlement means gains are received early and can be reinvested, and losses are paid early and have to be funded. If the underlying tends to rise when rates are high, the holder of a long future receives cash exactly when it can be reinvested best — which is worth something, and the futures price reflects it.
• Where that covariance is nil the two prices agree. On an equity index over a few months the difference is a rounding error; on a long-dated interest-rate contract it is not, and the adjustment has a name and a desk that computes it.
• The general lesson is worth more than the formula: two contracts with the same payoff and different timing are two different instruments, and the market prices the timing.

The comparison

Where each genuinely fits

• A future fits a liquid standard exposure where entering and leaving cheaply matters more than matching an exact date or size, and where the holder can fund a run of losing days without selling something else.
• A forward fits a specific commercial exposure — a payment in a currency on a date, a cargo of a grade at a port — where a standardised contract would leave a residual the hedger still has to manage. Hedging calls that residual basis risk, and it is the reason forwards survive.
• Neither removes the exposure, and this is the sentence both are most often described without: a hedge exchanges one risk for a smaller and differently shaped one.

Three questions that settle it

• Can I fund the worst plausible run of margin calls without unwinding the position that justifies them?
• Does a standard contract leave a residual, and is that residual smaller than the counterparty exposure I would take instead?
• Which am I actually measuring — the final outcome, or the path? The two contracts differ only on the second, and the second is what has caused the failures.