LOS c: Differentiate the basic characteristics of forward contracts, futures contracts, options (calls and puts), and swaps.

Each exchange has a clearinghouse. The clearinghouse guarantees that traders in the futures market will honor their obligations. The clearinghouse does this by splitting each trade once it is made and acting as the opposite side of each position. To safeguard the clearinghouse, the exchange requires traders to post margin and settle their accounts on a daily basis. Before trading, the trader must deposit funds (called margin) with their broker (who, in return, will post margin with the clearinghouse). The purpose of margin is to ensure that traders will perform their contractual obligations. Margin can be posted in cash, bank letters of credit, or in T-Bills.

The clearinghouse acts as the buyer to every seller and the seller to every buyer. By doing this, the clearinghouse allows either side of the trade to reverse positions later without having to contact the other side of the initial trade. This allows traders to enter the market knowing that they will be able to reverse their position any time that they want. Traders are also freed from having to worry about the other side of the trade defaulting, since the other side of their trade is now the clearinghouse. In the history of U.S. futures trading, the clearinghouse has never defaulted.

Explanations for other choices:

A reverse, or offsetting, trade in the futures market is how most futures positions are settled.  Since the other side of your position is held by the clearinghouse, if you make an exact opposite trade (maturity, quantity, and good) to your current position, the clearinghouse will net your positions out, leaving you with a zero balance. 

Listed below is additional information contrasting futures and forwards:

• Forwards are private contracts and do not trade on an organized exchange. Futures contracts trade on organized exchanges. 
• Forwards are unique contracts satisfying the needs of the parties involved. Futures contracts are highly standardized. A futures contract specifies the quantity, quality, delivery date, and delivery mechanism. 
• Forwards have default risk. The seller may not deliver, and the buyer may not accept delivery. With futures contracts, performance is guaranteed by the exchange’s clearinghouse.
• Forwards require no cash transactions until the delivery date. Futures contracts require that traders post margin money to trade. Margin is good faith money that supports the trader’s promise to fulfill their obligation.
• Forward contracts are usually not regulated. The government regulates futures markets.

 

A forward contract is traded in the over-the-counter market, not an exchange. Forward commitments is a broad term that could include forwards, futures, or swaps. Unlike forward contracts, futures contracts are standardized, which allows them to be traded on the exchange.

Futures contracts are standardized and subject to governmental and exchange regulation. They are actively traded in the secondary market.

A futures contract may be based on an equity price or return, but would be, in that case, an equity derivative. A futures contract is a forward contract that is standardized and exchange traded.

A swap consists of a series of forward commitments on multiple ‘settlement’ dates. A strap is an options strategy and a stack is a type of hedge.