Forward and Futures Contracts: Mechanics, Margins & Hedging

Forward and futures contracts are among the oldest and most fundamental derivative instruments in finance. Dating back centuries to agricultural markets where farmers and merchants sought to lock in prices for future harvests, these contracts have evolved into sophisticated tools used by corporations to manage risk, by speculators to express directional views, and by arbitrageurs to profit from pricing inefficiencies.

At their core, forwards and futures solve a simple problem: how do two parties agree today on a price for a transaction that will occur in the future? A wheat farmer facing uncertainty about harvest prices and a flour mill needing to budget for future grain purchases both benefit from the ability to fix a price now. This price certainty comes at a cost; neither party benefits if the market moves in their favor, but for many participants, eliminating downside risk is worth foregoing upside potential.

This chapter introduces the mechanics of forward and futures contracts, explains how they differ, and examines the infrastructure that makes futures markets work. You'll learn how margin requirements and daily settlement protect market participants from counterparty risk, how contract specifications standardize trading, and why these instruments have become essential tools for risk management across virtually every asset class.

A forward contract is a private agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. The party agreeing to buy the asset takes a long position, while the party agreeing to sell takes a short position. No money changes hands when the contract is initiated; the agreed price, called the forward price or delivery price, is set such that the contract has zero initial value to both parties.

Forward contracts trade over-the-counter (OTC), meaning they are negotiated directly between counterparties rather than through an exchange. This flexibility allows participants to customize every aspect of the contract: the underlying asset, the quantity, the delivery date, the delivery location, and any other terms relevant to their specific needs. A copper mining company might negotiate a forward contract for delivery of a specific grade of copper to a particular refinery on a date that aligns with its production schedule.

The payoff structure determines how profits and losses are calculated at maturity. At expiration, the outcome depends on the difference between the spot market price and the agreed forward price. This comparison determines whether entering the contract was beneficial or costly.

The payoff of a forward contract at maturity depends on the relationship between the spot price at expiration and the forward price agreed upon at initiation. For the long position, the holder has committed to buying the asset at the predetermined forward price. If the spot price at expiration exceeds this forward price, the long position holder can effectively purchase something worth more than they are paying. Conversely, if the spot price falls below the forward price, they are obligated to pay more than the asset is worth in the open market. This logic leads directly to the payoff formula:

where:

• $S_T$: spot price of the asset at expiration
• $K$: forward price agreed upon at initiation

The formula captures a simple but powerful idea: profit equals what you receive (an asset worth $S_T$) minus what you pay ($K$). If the spot price at maturity exceeds the forward price, the long position profits by receiving an asset worth more than they paid. The profit equals the difference between these prices. Conversely, if the spot price falls below the forward price, the long position loses because they are locked into paying more than the current market value.

For the short position, the economic reasoning is precisely reversed. The short position holder has committed to selling the asset at the forward price. They want the spot price to be low at expiration so that they can acquire the asset cheaply (if they don't already own it) and sell it at the higher contractual price. Their payoff is symmetric to the long position:

where:

• $K$: forward price agreed upon at initiation
• $S_T$: spot price of the asset at expiration

The short profits when prices fall and loses when prices rise. Notice that the sum of the two payoffs is always zero: $(S_T - K) + (K - S_T) = 0$. This reveals an important characteristic of forward contracts. Forwards are a zero-sum game between the counterparties. Every dollar gained by one party is a dollar lost by the other. No value is created or destroyed by the contract itself; rather, value is transferred between the parties based on how spot prices evolve. The following code calculates and visualizes the payoff profiles for both long and short positions across a range of possible spot prices at expiration.

The linear payoff structure of forwards contrasts sharply with options, which have asymmetric payoffs due to the optionality they provide. With a forward, both upside and downside are unlimited; you cannot walk away from the contract if prices move against you. This symmetry means that forwards provide pure exposure to price changes without the protective floor that options offer. The linearity also means that the sensitivity of the forward's value to the underlying price (its delta) is constant at 1.0 for a long position and -1.0 for a short position, regardless of where the spot price is trading.

The key parameters for the forward contract payoff are:

• K: Forward price agreed upon at initiation. This is the contractually fixed price at which delivery will occur, determined at the outset so that the contract has zero initial value to both parties. The forward price reflects the current spot price adjusted for the time value of money and any carrying costs or benefits associated with holding the underlying asset.
• S_T: Spot price of the asset at expiration. This is the prevailing market price at the time of delivery, which is unknown when the contract is initiated. Uncertainty about the future spot price creates both risk and opportunity.

The primary disadvantage of forward contracts is counterparty risk, the risk that one party will default on their obligation. If you've entered a forward contract to buy oil at $80 per barrel and the spot price rises to $120, your counterparty owes you $40 per barrel at maturity. If they are unable or unwilling to pay, you bear the loss despite having a valid contract.

Counterparty risk in forwards is particularly problematic for three reasons:

• Exposure grows over time: As prices move, the value of the contract to one party (and the liability to the other) can become substantial. A contract that was fairly priced at initiation might represent millions of dollars in exposure by maturity.

• No collateral requirement: Unlike futures, forward contracts typically don't require either party to post margin, meaning there's no buffer against default.

• Illiquidity: Because forwards are customized bilateral agreements, exiting a position before maturity is difficult. You cannot simply sell your contract on an exchange; you must either negotiate an early termination with your counterparty or enter an offsetting forward with a third party.

To mitigate counterparty risk, parties to forward contracts often use credit support annexes (CSAs) that require posting collateral as the contract's value changes, or they trade only with highly creditworthy counterparties.

Futures contracts evolved to address the limitations of forwards while preserving their economic purpose. A futures contract is a standardized agreement to buy or sell an asset at a specified future date, but unlike forwards, futures trade on organized exchanges with standardized terms and centralized clearing.

The standardization of futures contracts covers several key dimensions:

• Contract size: Each contract specifies a fixed quantity of the underlying. For example, one crude oil futures contract on the CME represents 1,000 barrels.

• Delivery date: Contracts mature on specific dates, typically identified by month and year (e.g., "December 2024 corn futures").

• Delivery specifications: For physically delivered contracts, the exchange specifies acceptable grades of the commodity, delivery locations, and delivery procedures.

• Tick size: The minimum price increment varies by contract; for example, crude oil futures might trade in increments of $0.01 per barrel

This standardization creates fungibility: one December 2024 corn futures contract is identical to any other, enabling buyers and sellers to trade anonymously on an exchange without negotiating terms.

The critical innovation that distinguishes futures from forwards is the clearinghouse. When two parties trade a futures contract on an exchange, the clearinghouse interposes itself between them, becoming the buyer to every seller and the seller to every buyer. This process, called novation, eliminates bilateral counterparty risk; instead of worrying about whether your specific counterparty will honor the contract, you only need to trust the clearinghouse.

Clearinghouses manage their risk through several mechanisms:

• Margin requirements: Both buyers and sellers must post collateral.
• Daily settlement: Gains and losses are settled each day rather than accumulating until maturity.
• Position limits: Maximum contract holdings prevent excessive concentration of risk.
• Default procedures: If a clearing member defaults, the clearinghouse has resources to cover losses.

The clearinghouse model has proven remarkably robust. Even during major market disruptions (such as the 1987 stock market crash, the 2008 financial crisis, and the 2020 pandemic volatility), major futures clearinghouses have continued to function and settle contracts.

The margin system is fundamental to understanding futures mechanics and represents an effective solution to counterparty risk in financial markets. Rather than allowing potential losses to accumulate over the life of a contract (as happens with forwards), the futures market settles gains and losses daily, ensuring that neither party ever owes the other an amount significantly larger than the collateral on deposit.

When you open a futures position, you don't pay the full contract value; instead, you deposit initial margin, a good-faith deposit typically representing 5-15% of the contract's notional value. This deposit serves as a performance bond, demonstrating your financial capacity to honor the contract and providing a buffer against potential losses.

The distinction between initial margin and a down payment is crucial for understanding futures economics. When you buy a house with a 10% down payment, you are purchasing equity in the property and financing the remainder. When you post 10% initial margin on a futures contract, you are not buying any portion of the underlying asset. Instead, you are posting collateral that can be seized if you fail to honor your contractual obligations. The full economic exposure to the underlying asset belongs to you from day one, but ownership of the asset itself never transfers until delivery (if physical settlement occurs).

Each trading day, the exchange settles all contracts at the official settlement price (typically based on trading activity near the close). The change in contract value from the previous day is immediately credited to or debited from your margin account, a process called marking to market. This daily settlement mechanism transforms what would be a single large payment at maturity into a series of smaller daily payments, dramatically reducing credit exposure between counterparties.

Consider going long one crude oil futures contract (1,000 barrels) at $75 per barrel. The following code simulates the daily marking-to-market process, tracking the margin balance as settlement prices change:

The simulation shows the marking-to-market process. On Day 1, prices rise from $75.00 to $76.20, generating a profit of $1,200 (1,000 barrels × $1.20). This amount is immediately credited to the margin account, which now stands at $7,200. You have 'realized' this gain even though the position remains open. On Day 2, prices fall to $74.80, and the loss of $1,400 is immediately debited from the account. The margin balance drops to $5,800 still above the maintenance threshold. The situation becomes more critical as prices continue to decline. By Day 4, with prices at $72.00, the cumulative loss of $3,000 has reduced the margin account to $3,000, which falls below the maintenance margin threshold of $4,500. This breach triggers a margin call.

The margin call mechanism is designed to ensure that losing positions are either adequately collateralized or closed before losses can exceed the available margin. When a margin call occurs, you must deposit enough funds to restore the account to the initial margin level, not just the maintenance margin. This restoration to the higher initial margin level, rather than merely the maintenance level, ensures adequate cushion for continued price movements and reduces the frequency of margin calls.

You must understand how initial margin, maintenance margin, and margin calls relate. The gap between these two levels provides a buffer that absorbs normal daily price fluctuations without triggering margin calls. Only when cumulative losses eat through this buffer does a margin call occur. The size of this buffer reflects the exchange's assessment of typical daily price volatility for the contract.

The daily settlement mechanism means that futures P&L is realized incrementally rather than all at expiration. This has important implications for financing: if you have a winning position, you receive cash daily and can earn interest on it, while a losing position requires ongoing funding. This timing difference between futures (daily settlement) and forwards (settlement at maturity) creates subtle but important pricing differences between the two instruments, particularly when interest rates are volatile or correlated with the underlying asset price.

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The key parameters for the margin calculation are:

• Initial Margin: The collateral required to open the position ($6,000). This amount is set by the exchange based on the contract's volatility and represents the expected maximum one-day loss at a high confidence level. Higher volatility contracts require larger initial margins.
• Maintenance Margin: The minimum balance required to keep the position open ($4,500). Typically set at 70-80% of initial margin, this threshold triggers margin calls when breached. The gap between initial and maintenance margin provides a buffer for normal daily fluctuations.
• Settlement Price: The daily closing price used to mark the position to market. This price is determined by the exchange based on trading activity near the close and serves as the official valuation for margin calculations.
• Contract size: The amount of the underlying asset per contract (1,000 barrels). This multiplier converts price changes per unit into dollar gains and losses per contract.

Most futures contracts offer two settlement methods:

Physical delivery requires the short position holder to deliver the actual underlying asset to the long position holder at a designated delivery point. For agricultural commodities, this might mean delivering grain to an approved warehouse. For crude oil, it means arranging pipeline delivery to Cushing, Oklahoma (for WTI futures). Physical delivery ensures that futures prices converge to spot prices at expiration; if they didn't, arbitrageurs would exploit the difference.

Cash settlement avoids the logistics of physical delivery. At expiration, the contract is marked to market against the final settlement price (often based on an index or reference rate), and the cash difference is exchanged. Stock index futures, for example, settle in cash because delivering a basket of 500 stocks would be impractical.

In practice, very few futures contracts result in physical delivery. Most traders close their positions before expiration by entering an offsetting trade. If you are long one December crude oil futures contract, you can exit by selling one December crude oil futures contract; the two positions net to zero.

While forwards and futures serve similar economic purposes, their structural differences have important practical implications:

The daily settlement of futures creates a subtle but important difference in pricing. Because futures gains and losses are realized daily while forward gains and losses accumulate until maturity, the two contract types have different exposures to interest rate movements. When asset prices and interest rates are positively correlated, futures are worth slightly more than forwards because gains are received (and can be reinvested) when rates are high. This difference is typically small but can matter for longer-dated contracts.

For most practical purposes, the prices of forwards and futures on the same underlying with the same maturity are very close, especially for short-dated contracts. The convenience of exchange trading, standardized contracts, and clearinghouse guarantee makes futures the preferred instrument for most market participants.

Futures exchanges offer contracts on a diverse range of underlying assets. Understanding the specifications of each contract is essential for trading.

Stock index futures allow traders to gain exposure to broad equity markets without owning individual stocks. The most actively traded index futures include:

• E-mini S&P 500 (ES): Tracks the S&P 500 index with a contract multiplier of $50 per index point. If the S&P 500 is at 4,500, one contract has notional value of $225,000.
• Nasdaq-100 (NQ): Tracks the Nasdaq-100 index with a $20 multiplier.
• Russell 2000 (RTY): Tracks small-cap stocks with a $50 multiplier.

Index futures are cash-settled because physical delivery of 500 stocks would be impractical. At expiration, the final settlement price is determined by a special opening quotation (SOQ) that uses the opening prices of all index constituents. The calculation below demonstrates how to analyze the leverage and sensitivity of an E-mini S&P 500 position:

Futures trading involves substantial leverage, which requires careful management. A 1% move in the S&P 500 represents a $11,250 gain or loss on this position, representing nearly 19% of the margin posted. This leverage amplifies both gains and losses. If you control $1,125,000 in notional equity exposure with only $60,000 in margin you have tremendous profit potential but also face the risk of losing your entire margin (and more) in a significant market move.

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The key parameters for the futures position analysis reveal the mechanics of leverage:

• Index Level: The current value of the S&P 500 index (4,500). This determines the baseline notional exposure when multiplied by the contract multiplier.
• Multiplier: The dollar value per index point ($50). This scaling factor translates abstract index points into concrete dollar amounts. Different index futures use different multipliers to achieve desired contract sizes.
• Contracts: The number of contracts held (5). Position sizing determines total exposure and should reflect your risk tolerance and capital base.
• Initial Margin: The total collateral posted for the position. The ratio of notional value to margin determines leverage, which in this case exceeds 18x.

Commodity futures originated with agricultural products and have expanded to include energy, metals, and other physical goods:

Energy contracts:

• Crude Oil (CL): 1,000 barrels per contract, physically settled at Cushing, Oklahoma
• Natural Gas (NG): 10,000 MMBtu per contract, delivered at Henry Hub
• Heating Oil (HO): 42,000 gallons per contract

Agricultural contracts:

• Corn (ZC): 5,000 bushels per contract
• Wheat (ZW): 5,000 bushels per contract
• Soybeans (ZS): 5,000 bushels per contract

Metals contracts:

• Gold (GC): 100 troy ounces per contract
• Silver (SI): 5,000 troy ounces per contract
• Copper (HG): 25,000 pounds per contract

Commodity futures have additional complexities including storage costs, quality specifications, and delivery point optionality. For example, COMEX gold futures allow delivery of gold bars meeting specific purity standards at approved vaults in New York.

Interest rate futures provide exposure to bond prices and interest rates:

• Treasury Bond Futures (ZB): Based on a notional $100,000 face value bond with a 6% coupon
• Treasury Note Futures (ZN): 10-year Treasury notes
• Eurodollar Futures (GE): Based on 3-month LIBOR rates (being replaced by SOFR futures)
• Fed Funds Futures (ZQ): Based on the effective federal funds rate

Treasury futures use a conversion factor system that allows delivery of various bonds while maintaining contract standardization. The "cheapest to deliver" bond optimization adds an additional layer of complexity to these contracts. Understanding the pricing mechanics requires familiarity with how Treasury futures quote prices in 32nds of a percentage point:

The calculated tick value of $31.25 indicates that each 1/32 price movement results in a profit or loss of $31.25 per contract. This convention of quoting in 32nds dates back to the pre-decimal era of Treasury trading and persists today because it allows for finer price gradations than decimal pricing would easily permit.

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The key parameters for the Treasury futures pricing illuminate the relationship between price quotes and dollar values:

• Face Value: The notional principal amount of the bond ($100,000). This represents the par value that the bond would pay at maturity and serves as the base for calculating contract value.
• Quoted Price: The market price expressed as a percentage of par. A quote of 112.50 means the contract is trading at 112.5% of face value, reflecting both the bond's coupon payments and prevailing interest rates.
• Tick Size: The minimum price increment (1/32 of a point). Treasury futures trade in 32nds, so a move from 112-16 to 112-17 represents a one-tick change. This convention allows for precise price discovery in highly liquid markets.

Currency futures trade on the CME and provide exposure to exchange rates:

• Euro FX (6E): €125,000 per contract
• Japanese Yen (6J): ¥12,500,000 per contract
• British Pound (6B): £62,500 per contract

Currency futures are quoted in U.S. dollars per unit of foreign currency and are used by corporations to hedge international exposure and by speculators to express views on relative currency movements.

The primary purpose of futures markets is risk transfer. We use futures to reduce or eliminate price risk associated with our business activities.

Consider an airline that will need to purchase 1 million gallons of jet fuel in three months. The airline faces the risk that fuel prices will rise, increasing its operating costs. To hedge this exposure, the airline can go long heating oil futures (a common proxy for jet fuel). The hedge works by creating a financial position whose gains offset losses on physical exposure, and vice versa. The calculation below demonstrates the number of contracts required and simulates the effective fuel cost under rising and falling price scenarios:

The hedge stabilizes the airline's effective fuel cost around $2.50 per gallon regardless of whether prices rise or fall. When prices rise, the futures gain offsets the higher physical fuel cost. When prices fall, the futures loss offsets the savings on physical fuel. The mechanism is symmetrical: the hedge removes both downside risk and upside opportunity, locking in a predictable cost that enables better financial planning.

The small differences from the target price arise from basis risk: the imperfect correlation between jet fuel and heating oil prices. Because no jet fuel futures contract exists with sufficient liquidity, the airline must use a proxy contract that doesn't perfectly track its actual exposure. This hedging imperfection is unavoidable when the hedged asset differs from the futures underlying.

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The key parameters for the hedging model capture the essential elements of hedge construction:

• Position to hedge: The total volume of fuel needed (1,000,000 gallons). This defines the physical exposure that the financial hedge must offset. Accurately measuring the exposure is the first step in any hedging program.
• Contract size: The volume of one heating oil contract (42,000 gallons). The contract size determines how many contracts are needed to match the exposure. In this case, the ratio yields approximately 24 contracts.
• Contracts needed: The calculated number of contracts to offset the risk. Because partial contracts cannot be traded, rounding introduces a small amount of residual exposure that remains unhedged.
• Effective price: The final cost per unit after accounting for both physical purchase and futures P&L. This measure captures the true economic outcome of the hedged position and should be relatively stable across price scenarios if the hedge is effective.

• Long hedge (buy futures): Used when you will need to purchase the underlying asset in the future. Examples include manufacturers hedging raw material costs, importers hedging currency exposure, and investors hedging future equity purchases.

• Short hedge (sell futures): Used when you will need to sell the underlying asset or have an existing long position. Examples include farmers hedging crop sales, oil producers hedging production, and portfolio managers hedging equity exposure.

A perfect hedge requires matching the futures position size to the underlying exposure. The hedge ratio calculates the number of contracts needed to match the dollar volatility of the position. The fundamental challenge in hedge construction is determining the right number of contracts: too few leaves residual exposure to price changes, while too many creates excess exposure in the opposite direction.

The hedge ratio formula scales the raw number of contracts (total position value divided by contract size) by the asset's sensitivity to futures price changes:

where:

• $h$: hedge ratio (number of contracts)
• $\text{Position to hedge}$: total value of the asset exposure
• $\text{Contract size}$: notional value of one futures contract
• $\beta$: sensitivity of the hedged asset to the futures price

The first term in this formula, the position to hedge divided by contract size, gives the number of contracts that would be needed if the hedged asset moved dollar-for-dollar with the futures contract. This "naive" hedge ratio assumes perfect correlation and identical volatility between the hedged asset and the futures contract.

However, real-world hedging situations rarely involve perfect correlation. The factor $\beta$ adjusts for the sensitivity of the hedged asset to the futures price. When the hedged asset is more volatile than the futures contract, beta exceeds 1.0 and more contracts are needed. When the hedged asset is less sensitive to price changes than the futures, beta is less than 1.0 and fewer contracts suffice.

For index futures hedging a stock portfolio, the beta coefficient can be estimated using standard regression techniques:

where:

• $\beta$: sensitivity coefficient (beta)
• $\text{Cov}(\cdot)$: covariance between returns, measuring how the portfolio and index move together
• $\text{Var}(\cdot)$: variance of returns, measuring the variability of the index
• $R_{\text{portfolio}}$: return on the portfolio being hedged
• $R_{\text{index}}$: return on the futures index

The formula defines beta as the ratio of covariance to variance. It normalizes the co-movement of the portfolio and index by the index's variance to determine the optimal hedge ratio. Intuitively, the covariance captures how much the portfolio and index tend to move together, while dividing by the index variance scales this co-movement relative to how much the index itself moves. A beta of 1.0 implies the portfolio moves in lockstep with the index, while a beta of 0.5 implies it is half as sensitive. A portfolio with beta of 1.3 would require 30% more futures contracts than the naive ratio would suggest.

Basis risk arises because the price of the asset being hedged doesn't move perfectly with the futures price. Even with the optimal hedge ratio, residual risk remains because the relationship between the hedged asset and the futures contract varies over time. The basis is defined as the difference between the spot price and the futures price:

where:

• $B$: the basis
• $S$: spot price of the asset
• $F$: futures price of the asset

The basis reflects the cost of carry (such as interest and storage) and convenience yield. In an efficient market, the basis converges to zero at expiration as arbitrage forces the futures price to equal the spot price at delivery. Before expiration, however, the basis fluctuates based on changes in carrying costs, supply and demand imbalances, and market expectations.

Changes in the basis create hedging imperfections. Even if we perfectly match the quantity of the physical position with futures contracts, basis movements introduce uncertainty about the final hedge outcome. Basis risk is minimized by choosing futures contracts that closely match the hedged asset and by using nearby expiration dates, which tend to track spot prices more closely than distant contracts.

While hedgers use futures to reduce risk, speculators use them to take on risk in pursuit of profit. The leverage inherent in futures trading makes them attractive for expressing directional views with limited capital.

If you believe crude oil prices will rise, you can go long oil futures rather than buying physical oil or oil company stocks. The advantages include:

• Leverage: Margin requirements are a fraction of notional value
• Liquidity: Active futures markets have tight bid-ask spreads
• Short selling: Going short is as easy as going long
• No storage: No need to handle physical commodities

We can quantify the potential risks and returns of a leveraged directional trade:

The leverage cuts both ways. A $7 decline in oil prices would produce a loss of $14,000, exceeding the $12,000 margin posted and triggering margin calls.

Sophisticated speculators often trade spreads (the difference between two related futures prices) rather than outright positions. Spread trades include:

• Calendar spreads: Long one expiration month, short another (e.g., long December, short March)
• Inter-commodity spreads: Long one commodity, short a related one (e.g., long crude oil, short heating oil)
• Inter-market spreads: The same commodity on different exchanges

Spreads typically have lower margin requirements than outright positions because the two legs partially offset each other's risk.

Modern futures markets involve several interconnected institutions:

• Exchanges provide the trading venue, establish contract specifications, and ensure orderly markets. Major exchanges include CME Group (Chicago), ICE (Atlanta/London), and Eurex (Frankfurt). Most trading now occurs electronically rather than in open-outcry trading pits.

• Clearinghouses guarantee contract performance, manage margin, and handle default procedures. The CME Clearing House, ICE Clear, and Options Clearing Corporation are examples. Clearinghouses are among the most systemically important financial institutions.

• Futures Commission Merchants (FCMs) are intermediaries that execute trades and maintain customer margin accounts. Retail traders and institutional investors access futures markets through FCMs.

• Regulators oversee futures markets to ensure fair and transparent trading. In the United States, the Commodity Futures Trading Commission (CFTC) regulates futures markets, while the National Futures Association (NFA) provides self-regulatory oversight.

Futures contracts are powerful tools, but they come with important limitations that you must understand.

Standardization constraints cut both ways. While standardization enables liquidity and transparent pricing, it prevents perfect customization. A company with exposure to a specific grade of commodity at a non-standard location faces basis risk. A portfolio that doesn't match any available index future requires cross-hedging. The mismatch between standardized contracts and actual exposures is a persistent source of hedging imperfection.

Margin and financing requirements can create cash flow challenges. If you are fundamentally protected against price movements, you may still face liquidity pressure from margin calls during adverse market moves. An airline hedged against rising fuel prices still needs cash to meet margin calls if prices temporarily spike, even though their physical fuel costs will also rise, offsetting the futures losses. This timing mismatch has caused problems for even sophisticated hedgers, most famously Metallgesellschaft's $1.3 billion loss in 1993 despite having a theoretically sound hedge.

Rolling costs affect long-term positions. Because futures contracts expire, maintaining ongoing exposure requires periodically closing expiring positions and opening new ones in later-dated contracts. If later-dated contracts are more expensive than near-term contracts (contango), rolling incurs a cost. Commodity ETFs that maintain futures positions face persistent drag from negative roll yields in contango markets. The USO oil ETF, for example, has significantly underperformed spot oil prices over time due to rolling costs.

Liquidity concentration in front-month contracts means that longer-dated hedges may face wider bid-ask spreads and greater price impact. A corporate treasurer hedging a three-year currency exposure may find that liquid futures markets only extend six months out, requiring a series of shorter hedges that must be rolled forward.

Despite these limitations, futures markets have transformed risk management across virtually every sector of the economy. Airlines hedge fuel, food companies hedge ingredients, multinational corporations hedge currencies, and pension funds hedge equity exposure. The development of liquid, standardized futures contracts with clearinghouse guarantees was a crucial financial innovation that enabled the globalized, interconnected economy we have today.

This chapter introduced the fundamental concepts and mechanics of forward and futures contracts. The key takeaways are:

• Forward contracts are private bilateral agreements to exchange an asset at a future date for a price agreed today. They offer customization but expose both parties to counterparty risk.

• Futures contracts are standardized, exchange-traded versions of forwards. The clearinghouse interposes itself between all parties, eliminating bilateral counterparty risk through margin requirements and daily settlement.

• Margin mechanics require you to post initial margin and maintain a minimum balance. Daily marking to market settles gains and losses incrementally, and margin calls ensure accounts stay adequately funded.

• Settlement can be physical (delivering the underlying asset) or cash (exchanging the monetary difference). Most positions are closed before expiration rather than settled.

• Contract specifications standardize the underlying asset, quantity, delivery date, and settlement procedures. This standardization enables anonymous trading on exchanges.

• Common underlyings include stock indices, commodities, interest rates, and currencies, each with specific contract conventions and trading practices.

• Hedging uses futures to reduce price risk by taking positions opposite to an underlying exposure. Basis risk arises when the hedged asset doesn't move perfectly with the futures price.

• Speculation uses futures leverage to express directional views with limited capital. The same leverage that amplifies gains also amplifies losses.

The futures market infrastructure (exchanges, clearinghouses, and brokers) provides the institutional framework that makes liquid, transparent, and safe derivatives trading possible. In subsequent chapters, we'll explore how futures are priced, how arbitrage relationships link futures to spot markets, and how to construct more sophisticated hedging strategies.

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