A commodity trader locks in a sale price on 10,000 barrels of crude oil using a forward contract. Three months later, oil drops 20%. The trader pockets the difference, no margin calls, no exchange involvement, just a private agreement. That single transaction touches cost-of-carry pricing, counterparty risk, and the mechanics of over-the-counter (OTC) derivatives. OTC markets let counterparties customize terms outside an exchange, so a hedger can match quantity, dates, and settlement to the exact exposure, at the cost of bilateral credit risk.
A forward contract is a private, customized agreement between two parties to buy or sell an asset at a specified price on a future date. No exchange is involved. Terms (quantity, delivery date, settlement method) are negotiated directly.
A futures contract does the same economic job but through an exchange. Contracts are standardized. A clearinghouse sits between buyer and seller, substantially reducing counterparty risk. Futures use daily settlement (marking to market), the operational difference that drives everything else.
Common mistakes
- Restoring margin to maintenance instead of initial margin. When a margin call hits, you must restore to the initial margin level, not the maintenance margin. If initial is $10,000, maintenance is $7,500, and your balance is $6,800, the deposit is $10,000 - $6,800 = $3,200.
- Confusing FRA notation. A "3x9 FRA" covers a 6-month loan starting in 3 months, not a 3-month loan starting in 9 months or a 9-month loan starting in 3 months. Subtract the first number from the second (9 - 3 = 6) to get the loan period.
- Reversing the hedge direction. A short stock position needs long calls for protection (calls gain when price rises, offsetting short stock losses). A long stock position needs long puts. Buying puts for a short stock position does nothing useful, it increases your downward directional bet.
Bottom line
- Forwards are OTC and customized, generally retaining greater bilateral counterparty risk depending on collateral; futures are exchange-traded and standardized, and daily settlement, margin, and the clearinghouse substantially reduce (but do not eliminate) counterparty risk.
- Marking-to-market accelerates cash flows, giving futures higher price risk, and shifts levels: futures price exceeds forward when spot and rates are positively correlated, equals it when uncorrelated, and falls below it when negatively correlated.
- Forward price = Spot x e^((r + storage costs - convenience yield) x T), an upper bound when the commodity cannot be shorted; an existing forward's value to the long is P(t) x e^((r + c - y)(T - t))...
- Long-term futures exposure requires rolling front-month into deferred contracts, so the roll schedule drives long-run returns; FRA notation "AxB" means settlement in A months over a (B minus A)-month loan, and the FRA rate is implied as [T x r(T)...
Exam shortcut
In a margin call scenario, go straight to initial margin minus current balance. Do not compute maintenance minus current balance, which understates the required deposit. For FRA notation, remember: "first number is when, difference is how long." A 3x9 starts in 3 months and lasts 6. A 6x12 starts in 6 months and lasts 6. Subtract to get the loan period.
The full lesson (about 9,839 words, 66 min read) adds 3 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- defining alts
- blurred lines
- risk return characteristics
- goals
- history us
- history asia
- buy sell side
- service providers
- legal structures
- fund types
- fund features
- fund terms
- drawdown fees
- waterfall calcs
- hedge fund fees
- fees and behavior
- return math
- irr
- irr problems
- modified irr
- other measures
- j curve
- notional principal
- return distributions
- moments
- covariance correlation
- beta autocorrelation
- std dev variance
- normality testing
- market efficiency
- time value
- forward rates
- binomial trees
- single-factor default-free bond models
- reduced-form modeling credit risk
- single-factor equity pricing models
- single factor models
- hypothesis testing
- sampling problems
- forwards vs futures
- forward foundations
- forwards on rates
- carry forwards
- managing long short
- option exposures
- rate options
- option pricing
- risk measures
- var
- benchmarking
- ratio measures
- risk adjusted
- estimating alpha
- pricing data
- appraisals smoothing
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