A Forward contract is the simplest form of a contingent claim that can be derived from an asset, since it does not contain any element of choice. Two parties agree, on a future delivery date , to exchange an underlying asset for a predetermined amount of cash called the delivery price . The underlying can be any kind of asset (e.g. commodities, shares, currencies) that has a fluctuating spot price ; on the delivery date , the terminal payoff is simply calculated from the difference between the spot and the delivery price
The opposite is true for the party who enters a short forward position (right): the holder has both the right and the obligation to sell the underlying with a maximum profit of and potential losses that are unlimited if the underlying becomes arbitrarily expensive . To avoid the unnecessary exchange of cash on the day when the contract is written, the delivery price is sometimes chosen equal to the forward price , which, by definition, makes the initial value of the contract worthless .
A futures contract is a special
type of forward contract with standardized delivery dates and sizes that
allow trading on an exchange: (2.1.2#tab.1) shows an example of a
commodity future that enables the owner of a contract to buy one tone
of wheat some time in the future.
A system of margin requirements is
designed to protect both parties against default: instead of realizing the
profit or the loss at the expiry date, futures are evaluated every day and
margin payments are made across
gradually over the lifetime of the contract.
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