Читать книгу Derivatives - Pirie Wendy L. - Страница 15

Forward commitments are contracts entered into at one point in time that require both parties to engage in a transaction at a later point in time (the expiration) on terms agreed upon at the start. The parties establish the identity and quantity of the underlying, the manner in which the contract will be executed or settled when it expires, and the fixed price at which the underlying will be exchanged. This fixed price is called the forward price.

As a hypothetical example of a forward contract, suppose that today Markus and Johannes enter into an agreement that Markus will sell his BMW to Johannes for a price of €30,000. The transaction will take place on a specified date, say, 180 days from today. At that time, Markus will deliver the vehicle to Johannes’s home and Johannes will give Markus a bank-certified check for €30,000. There will be no recourse, so if the vehicle has problems later, Johannes cannot go back to Markus for compensation. It should be clear that both Markus and Johannes must do their due diligence and carefully consider the reliability of each other. The car could have serious quality issues and Johannes could have financial problems and be unable to pay the €30,000. Obviously, the transaction is essentially unregulated. Either party could renege on his obligation, in response to which the other party could go to court, provided a formal contract exists and is carefully written. Note finally that one of the two parties is likely to end up gaining and the other losing, depending on the secondary market price of this type of vehicle at expiration of the contract.

This example is quite simple but illustrates the essential elements of a forward contract. In the financial world, such contracts are very carefully written, with legal provisions that guard against fraud and require extensive credit checks. Now let us take a deeper look at the characteristics of forward contracts.

4.1.1 Forward Contracts

The following is the formal definition of a forward contract:

A forward contract is an over-the-counter derivative contract in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date at a fixed price they agree on when the contract is signed.

In addition to agreeing on the price at which the underlying asset will be sold at a later date, the two parties also agree on several other matters, such as the specific identity of the underlying, the number of units of the underlying that will be delivered, and where the future delivery will occur. These are important points but relatively minor in this discussion, so they can be left out of the definition to keep it uncluttered.

As noted earlier, a forward contract is a commitment. Each party agrees that it will fulfill its responsibility at the designated future date. Failure to do so constitutes a default and the non-defaulting party can institute legal proceedings to enforce performance. It is important to recognize that although either party could default to the other, only one party at a time can default. The party owing the greater amount could default to the other, but the party owing the lesser amount cannot default because its claim on the other party is greater. The amount owed is always based on the net owed by one party to the other.

To gain a better understanding of forward contracts, it is necessary to examine their payoffs. As noted, forward contracts – and indeed all derivatives – take (derive) their payoffs from the performance of the underlying asset. To illustrate the payoff of a forward contract, start with the assumption that we are at time t = 0 and that the forward contract expires at a later date, time t = T.5 The spot price of the underlying asset at time 0 is S₀ and at time T is S_T. Of course, when we initiate the contract at time 0, we do not know what S_T will ultimately be. Remember that the two parties, the buyer and the seller, are going long and short, respectively.

At time t = 0, the long and the short agree that the short will deliver the asset to the long at time T for a price of F₀(T ). The notation F₀(T) denotes that this value is established at time 0 and applies to a contract expiring at time T. F₀(T) is the forward price. Later, you will learn how the forward price is determined. It turns out that it is quite easy to do, but we do not need to know right now.6

So, let us assume that the buyer enters into the forward contract with the seller for a price of F₀(T ), with delivery of one unit of the underlying asset to occur at time T. Now, let us roll forward to time T, when the price of the underlying is S_T. The long is obligated to pay F₀(T ), for which he receives an asset worth S_T. If S_T > F₀(T ), it is clear that the transaction has worked out well for the long. He paid F₀(T) and receives something of greater value. Thus, the contract effectively pays off S_T ‒ F₀(T) to the long, which is the value of the contract at expiration. The short has the mirror image of the long. He is required to deliver the asset worth S_T and accept a smaller amount, F₀(T ). The contract has a payoff for him of F₀(T) ‒ S_T, which is negative. Even if the asset’s value, S_T, is less than the forward price, F₀(T ), the payoffs are still S_T ‒ F₀(T) for the long and F₀(T) ‒ S_T for the short. We can consolidate these results by writing the short’s payoff as the negative of the long’s, ‒[S_T ‒ F₀(T )], which serves as a useful reminder that the long and the short are engaged in a zero-sum game, which is a type of competition in which one participant’s gains are the other’s losses. Although both lose a modest amount in the sense of both having some costs to engage in the transaction, these costs are relatively small and worth ignoring for our purposes at this time. In addition, it is worthwhile to note how derivatives transform the performance of the underlying. The gain from owning the underlying would be S_T ‒ S₀, whereas the gain from owning the forward contract would be S_T ‒ F₀(T ). Both figures are driven by S_T, the price of the underlying at expiration, but they are not the same.

Exhibit 1 illustrates the payoffs from both buying and selling a forward contract.

EXHIBIT 1 Payoffs from a Forward Contract

The long hopes the price of the underlying will rise above the forward price, F₀(T ), whereas the short hopes the price of the underlying will fall below the forward price. Except in the extremely rare event that the underlying price at T equals the forward price, there will ultimately be a winner and a loser.

An important element of forward contracts is that no money changes hands between parties when the contract is initiated. Unlike in the purchase and sale of an asset, there is no value exchanged at the start. The buyer does not pay the seller some money and obtain something. In fact, forward contracts have zero value at the start. They are neither assets nor liabilities. As you will learn in later readings, their values will deviate from zero later as prices move. Forward contracts will almost always have non-zero values at expiration.

As noted previously, the primary purpose of derivatives is for risk management. Although the uses of forward contracts are covered in depth later in the curriculum, there are a few things to note here about the purposes of forward contracts. It should be apparent that locking in the future buying or selling price of an underlying asset can be extremely attractive for some parties. For example, an airline anticipating the purchase of jet fuel at a later date can enter into a forward contract to buy the fuel at a price agreed upon when the contract is initiated. In so doing, the airline has hedged its cost of fuel. Thus, forward contracts can be structured to create a perfect hedge, providing an assurance that the underlying asset can be bought or sold at a price known when the contract is initiated. Likewise, speculators, who ultimately assume the risk laid off by hedgers, can make bets on the direction of the underlying asset without having to invest the money to purchase the asset itself.

Finally, forward contracts need not specifically settle by delivery of the underlying asset. They can settle by an exchange of cash. These contracts – called non-deliverable forwards (NDFs), cash-settled forwards, or contracts for differences– have the same economic effect as do their delivery-based counterparts. For example, for a physical delivery contract, if the long pays F₀(T) and receives an asset worth S_T, the contract is worth S_T – F₀(T) to the long at expiration. A non-deliverable forward contract would have the short simply pay cash to the long in the amount of S_T – F₀(T ). The long would not take possession of the underlying asset, but if he wanted the asset, he could purchase it in the market for its current price of S_T. Because he received a cash settlement in the amount of S_T – F₀(T ), in buying the asset the long would have to pay out only S_T – [S_T – F₀(T )], which equals F₀(T ). Thus, the long could acquire the asset, effectively paying F₀(T ), exactly as the contract promised. Transaction costs do make cash settlement different from physical delivery, but this point is relatively minor and can be disregarded for our purposes here.

As previously mentioned, forward contracts are OTC contracts. There is no formal forward contract exchange. Nonetheless, there are exchange-traded variants of forward contracts, which are called futures contracts or just futures.

4.1.2 Futures

Futures contracts are specialized versions of forward contracts that have been standardized and that trade on a futures exchange. By standardizing these contracts and creating an organized market with rules, regulations, and a central clearing facility, the futures markets offer an element of liquidity and protection against loss by default.

Formally, a futures contract is defined as follows:

A futures contract is a standardized derivative contract created and traded on a futures exchange in which two parties agree that one party, the buyer, will purchase an underlying asset from the other party, the seller, at a later date and at a price agreed on by the two parties when the contract is initiated and in which there is a daily settling of gains and losses and a credit guarantee by the futures exchange through its clearinghouse.

First, let us review what standardization means. Recall that in forward contracts, the parties customize the contract by specifying the underlying asset, the time to expiration, the delivery and settlement conditions, and the quantity of the underlying, all according to whatever terms they agree on. These contracts are not traded on an exchange. As noted, the regulation of OTC derivatives markets is increasing, but these contracts are not subject to the traditionally high degree of regulation that applies to securities and futures markets. Futures contracts first require the existence of a futures exchange, a legally recognized entity that provides a market for trading these contracts. Futures exchanges are highly regulated at the national level in all countries. These exchanges specify that only certain contracts are authorized for trading. These contracts have specific underlying assets, times to expiration, delivery and settlement conditions, and quantities. The exchange offers a facility in the form of a physical location and/or an electronic system as well as liquidity provided by authorized market makers.

Probably the most important distinctive characteristic of futures contracts is the daily settlement of gains and losses and the associated credit guarantee provided by the exchange through its clearinghouse. When a party buys a futures contract, it commits to purchase the underlying asset at a later date and at a price agreed upon when the contract is initiated. The counterparty (the seller) makes the opposite commitment, an agreement to sell the underlying asset at a later date and at a price agreed upon when the contract is initiated. The agreed-upon price is called the futures price. Identical contracts trade on an ongoing basis at different prices, reflecting the passage of time and the arrival of new information to the market. Thus, as the futures price changes, the parties make and lose money. Rising (falling) prices, of course, benefit (hurt) the long and hurt (benefit) the short. At the end of each day, the clearinghouse engages in a practice called mark to market, also known as the daily settlement. The clearinghouse determines an average of the final futures trades of the day and designates that price as the settlement price. All contracts are then said to be marked to the settlement price. For example, if the long purchases the contract during the day at a futures price of £120 and the settlement price at the end of the day is £122, the long’s account would be marked for a gain of £2. In other words, the long has made a profit of £2 and that amount is credited to his account, with the money coming from the account of the short, who has lost £2. Naturally, if the futures price decreases, the long loses money and is charged with that loss, and the money is transferred to the account of the short.7

The account is specifically referred to as a margin account. Of course, in equity markets, margin accounts are commonly used, but there are significant differences between futures margin accounts and equity margin accounts. Equity margin accounts involve the extension of credit. An investor deposits part of the cost of the stock and borrows the remainder at a rate of interest. With futures margin accounts, both parties deposit a required minimum sum of money, but the remainder of the price is not borrowed. This required margin is typically less than 10 % of the futures price, which is considerably less than in equity margin trading. In the example above, let us assume that the required margin is £10, which is referred to as the initial margin. Both the long and the short put that amount into their respective margin accounts. This money is deposited there to support the trade, not as a form of equity, with the remaining amount borrowed. There is no formal loan created as in equity markets. A futures margin is more of a performance bond or good faith deposit, terms that were previously mentioned. It is simply an amount of money put into an account that covers possible future losses.

Associated with each initial margin is another figure called the maintenance margin. The maintenance margin is the amount of money that each participant must maintain in the account after the trade is initiated, and it is always significantly lower than the initial margin. Let us assume that the maintenance margin in this example is £6. If the buyer’s account is marked to market with a credit of £2, his margin balance moves to £12, while the seller’s account is charged £2 and his balance moves to £8. The clearinghouse then compares each participant’s balance with the maintenance margin. At this point, both participants more than meet the maintenance margin.

Let us say, however, that the price continues to move in the long’s favor and, therefore, against the short. A few days later, assume that the short’s balance falls to £4, which is below the maintenance margin requirement of £6. The short will then get a margin call, which is a request to deposit additional funds. The amount that the short has to deposit, however, is not the £2 that would bring his balance up to the maintenance margin. Instead, the short must deposit enough funds to bring the balance up to the initial margin. So, the short must come up with £6. The purpose of this rule is to get the party’s position significantly above the minimum level and provide some breathing room. If the balance were brought up only to the maintenance level, there would likely be another margin call soon. A party can choose not to deposit additional funds, in which case the party would be required to close out the contract as soon as possible and would be responsible for any additional losses until the position is closed.

As with forward contracts, neither party pays any money to the other when the contract is initiated. Value accrues as the futures price changes, but at the end of each day, the mark-to-market process settles the gains and losses, effectively resetting the value for each party to zero.

The clearinghouse moves money between the participants, crediting gains to the winners and charging losses to the losers. By doing this on a daily basis, the gains and losses are typically quite small, and the margin balances help ensure that the clearinghouse will collect from the party losing money. As an extra precaution, in fast-moving markets, the clearinghouse can make margin calls during the day, not just at the end of the day. Yet there still remains the possibility that a party could default. A large loss could occur quickly and consume the entire margin balance, with additional money owed.8 If the losing party cannot pay, the clearinghouse provides a guarantee that it will make up the loss, which it does by maintaining an insurance fund. If that fund were depleted, the clearinghouse could levy a tax on the other market participants, though that has never happened.

Some futures contracts contain a provision limiting price changes. These rules, called price limits, establish a band relative to the previous day’s settlement price, within which all trades must occur. If market participants wish to trade at a price above the upper band, trading stops, which is called limit up, until two parties agree on a trade at a price lower than the upper limit. Likewise, if market participants wish to trade at a price below the lower band, which is called limit down, no trade can take place until two parties agree to trade at a price above the lower limit. When the market hits these limits and trading stops, it is called locked limit. Typically, the exchange rules provide for an expansion of the limits the next day. These price limits, which may be somewhat objectionable to proponents of free markets, are important in helping the clearinghouse manage its credit exposure. Just because two parties wish to trade a futures contract at a price beyond the limits does not mean they should be allowed to do so. The clearinghouse is a third participant in the contract, guaranteeing to each party that it ensures against the other party defaulting. Therefore, the clearinghouse has a vested interest in the price and considerable exposure. Sharply moving prices make it more difficult for the clearinghouse to collect from the parties losing money.

Most participants in futures markets buy and sell contracts, collecting their profits and incurring their losses, with no ultimate intent to make or take delivery of the underlying asset. For example, the long may ultimately sell her position before expiration. When a party re-enters the market at a later date but before expiration and engages in the opposite transaction – a long selling her previously opened contract or a short buying her previously opened contract – the transaction is referred to as an offset. The clearinghouse marks the contract to the current price relative to the previous settlement price and closes out the participant’s position.

At any given time, the number of outstanding contracts is called the open interest. Each contract counted in the open interest has a long and a corresponding short. The open interest figure changes daily as some parties open up new positions, while other parties offset their old positions. It is theoretically possible that all longs and shorts offset their positions before expiration, leaving no open interest when the contract expires, but in practice there is nearly always some open interest at expiration, at which time there is a final delivery or settlement.

When discussing forward contracts, we noted that a contract could be written such that the parties engage in physical delivery or cash settlement at expiration. In the futures markets, the exchange specifies whether physical delivery or cash settlement applies. In physical delivery contracts, the short is required to deliver the underlying asset at a designated location and the long is required to pay for it. Delivery replaces the mark-to-market process on the final day. It also ensures an important principle that you will use later: The futures price converges to the spot price at expiration. Because the short delivers the actual asset and the long pays the current spot price for it, the futures price at expiration has to be the spot price at that time. Alternatively, a futures contract initiated right at the instant of expiration is effectively a spot transaction and, therefore, the futures price at expiration must equal the spot price. Following this logic, in cash settlement contracts, there is a final mark to market, with the futures price formally set to the spot price, thereby ensuring automatic convergence.

In discussing forward contracts, we described the process by which they pay off as the spot price at expiration minus the forward price, S_T – F₀(T ), the former determined at expiration and the latter agreed upon when the contract is initiated. Futures contracts basically pay off the same way, but there is a slight difference. Let us say the contract is initiated on Day 0 and expires on Day T. The intervening days are designated Days 1, 2, … T. The initial futures price is designated f₀(T) and the daily settlement prices on Days 1, 2, … T are designated f₁(T ), f₂(T ), … f_T(T ). There are, of course, futures prices within each trading day, but let us focus only on the settlement prices for now. For simplicity, let us assume that the long buys at the settlement price on Day 0 and holds the position all the way to expiration. Through the mark-to-market process, the cash flows to the account of the long will be

These add up to

And because of the convergence of the final futures price to the spot price,

which is the same as with forward contracts.9 Note, however, that the timing of these profits is different from that of forwards. Forward contracts realize the full amount, S_T – f₀(T ), at expiration, whereas futures contracts realize this amount in parts on a day-to-day basis. Naturally, the time value of money principle says that these are not equivalent amounts of money. But the differences tend to be small, particularly in low-interest-rate environments, some of these amounts are gains and some are losses, and most futures contracts have maturities of less than a year.

But the near equivalence of the profits from a futures and a forward contract disguises an important distinction between these types of contracts. In a forward contact, with the entire payoff made at expiration, a loss by one party can be large enough to trigger a default. Hence, forward contracts are subject to default and require careful consideration of the credit quality of the counterparties. Because futures contracts settle gains and collect losses daily, the amounts that could be lost upon default are much smaller and naturally give the clearinghouse much greater flexibility to manage the credit risk it assumes.

Unlike forward markets, futures markets are highly regulated at the national level. National regulators are required to approve new futures exchanges and even new contracts proposed by existing exchanges as well as changes in margin requirements, price limits, and any significant changes in trading procedures. Violations of futures regulations can be subject to governmental prosecution. In addition, futures markets are far more transparent than forward markets. Futures prices, volume, and open interest are widely reported and easily obtained. Futures prices of nearby expiring contracts are often used as proxies for spot prices, particularly in decentralized spot markets, such as gold, which trades in spot markets all over the world.

In spite of the advantages of futures markets over forward markets, forward markets also have advantages over futures markets. Transparency is not always a good thing. Forward markets offer more privacy and fewer regulatory encumbrances. In addition, forward markets offer more flexibility. With the ability to tailor contracts to the specific needs of participants, forward contracts can be written exactly the way the parties want. In contrast, the standardization of futures contracts makes it more difficult for participants to get exactly what they want, even though they may get close substitutes. Yet, futures markets offer a valuable credit guarantee.

Like forward markets, futures markets can be used for hedging or speculation. For example, a jewelry manufacturer can buy gold futures, thereby hedging the price it will have to pay for one of its key inputs. Although it is more difficult to construct a futures strategy that hedges perfectly than to construct a forward strategy that does so, futures offer the benefit of the credit guarantee. It is not possible to argue that futures are better than forwards or vice versa. Market participants always trade off advantages against disadvantages. Some participants prefer futures, and some prefer forwards. Some prefer one over the other for certain risks and the other for other risks. Some might use one for a particular risk at a point in time and a different instrument for the same risk at another point in time. The choice is a matter of taste and constraints.

The third and final type of forward commitment we will cover is swaps. They go a step further in committing the parties to buy and sell something at a later date: They obligate the parties to a sequence of multiple purchases and sales.

4.1.3 Swaps

The concept of a swap is that two parties exchange (swap) a series of cash flows. One set of cash flows is variable or floating and will be determined by the movement of an underlying asset or rate. The other set of cash flows can be variable and determined by a different underlying asset or rate, or it can be fixed. Formally, a swap is defined as follows:

A swap is an over-the-counter derivative contract in which two parties agree to exchange a series of cash flows whereby one party pays a variable series that will be determined by an underlying asset or rate and the other party pays either (1) a variable series determined by a different underlying asset or rate or (2) a fixed series.

As with forward contracts, swap contracts also contain other terms – such as the identity of the underlying, the relevant payment dates, and the payment procedure – that are negotiated between the parties and written into the contract. A swap is a bit more like a forward contract than a futures contract in that it is an OTC contract, so it is privately negotiated and subject to default. Nonetheless, the similarities between futures and forwards apply to futures and swaps and, indeed, combinations of futures contracts expiring at different dates are often compared to swaps.

As with forward contracts, either party can default but only one party can default at a particular time. The money owed is always based on the net owed by one party to the other. Hence, the party owing the lesser amount cannot default to the party owing the greater amount. Only the latter can default, and the amount it owes is the net of what it owes and what is owed to it, which is also true with forwards.

Swaps are relatively young financial instruments, having been created only in the early 1980s. Thus, it may be somewhat surprising to learn that the swap is the most widely used derivative, a likely result of its simplicity and embracement by the corporate world. The most common swap is the fixed-for-floating interest rate swap. In fact, this type of swap is so common that it is often called a “plain vanilla swap” or just a “vanilla swap,” owing to the notion that vanilla ice cream is considered plain (albeit tasty).

Let us examine a scenario in which the vanilla interest rate swap is frequently used. Suppose a corporation borrows from a bank at a floating rate. It would prefer a fixed rate, which would enable it to better anticipate its cash flow needs in making its interest payments.10 The corporation can effectively convert its floating-rate loan to a fixed-rate loan by adding a swap, as shown in Exhibit 2.

EXHIBIT 2 Using an Interest Rate Swap to Convert a Floating-Rate Loan to a Fixed-Rate Loan

The interest payments on the loan are tied to a specific floating rate. For a dollar-based loan, that rate has typically been US dollar Libor.11 The payments would be based on the rate from the Libor market on a specified reset date times the loan balance times a factor reflecting the number of days in the current interest calculation period. The actual payment is made at a later date. Thus, for a loan balance of, say, $10 million with monthly payments, the rate might be based on Libor on the first business day of the month, with interest payable on the first business day of the next month, which is the next reset date, and calculated as $10 million times the rate times 30/360. The 30/360 convention, an implicit assumption of 30 days in a month, is common but only one of many interest calculation conventions used in the financial world. Often, “30” is replaced by the exact number of days since the last interest payment. The use of a 360-day year is a common assumption in the financial world, which originated in the pre-calculator days when an interest rate could be multiplied by a number like 30/360, 60/360, 90/360, etc., more easily than if 365 were used.

Whatever the terms of the loan are, the terms of the swap are typically set to match those of the loan. Thus, a Libor-based loan with monthly payments based on the 30/360 convention would be matched with a swap with monthly payments based on Libor and the 30/360 convention and the same reset and payment dates. Although the loan has an actual balance (the amount owed by borrower to creditor), the swap does not have such a balance owed by one party to the other. Thus, it has no principal, but it does have a balance of sorts, called the notional principal, which ordinarily matches the loan balance. A loan with only one principal payment, the final one, will be matched with a swap with a fixed notional principal. An amortizing loan, which has a declining principal balance, will be matched with a swap with a pre-specified declining notional principal that matches the loan balance.

As with futures and forwards, no money changes hands at the start; thus, the value of a swap when initiated must be zero. The fixed rate on the swap is determined by a process that forces the value to zero, a procedure that will be covered later in the curriculum. As market conditions change, the value of a swap will deviate from zero, being positive to one party and negative to the other.

As with forward contracts, swaps are subject to default, but because the notional amount of a swap is not typically exchanged, the credit risk of a swap is much less than that of a loan.12 The only money passing from one party to the other is the net difference between the fixed and floating interest payments. In fact, the parties do not even pay each other. Only one party pays the other, as determined by the net of the greater amount owed minus the lesser amount. This does not mean that swaps are not subject to a potentially large amount of credit risk. At a given point in time, one party could default, effectively owing the value of all remaining payments, which could substantially exceed the value that the non-defaulting party owes to the defaulting party. Thus, there is indeed credit risk in a swap. This risk must be managed by careful analysis before the transaction and by the potential use of such risk-mitigating measures as collateral.

There are also interest rate swaps in which one party pays on the basis of one interest rate and the other party pays on the basis of a different interest rate. For example, one party might make payments at Libor, whereas the other might make payments on the basis of the US Treasury bill rate. The difference between Libor and the T-bill rate, often called the TED spread (T-bills versus Eurodollar), is a measure of the credit risk premium of London banks, which have historically borrowed short term at Libor, versus that of the US government, which borrows short term at the T-bill rate. This transaction is called a basis swap. There are also swaps in which the floating rate is set as an average rate over the period, in accordance with the convention for many loans. Some swaps, called overnight indexed swaps, are tied to a Fed funds–type rate, reflecting the rate at which banks borrow overnight. As we will cover later, there are many other different types of swaps that are used for a variety of purposes. The plain vanilla swap is merely the simplest and most widely used.

Because swaps, forwards, and futures are forward commitments, they can all accomplish the same thing. One could create a series of forwards or futures expiring at a set of dates that would serve the same purpose as a swap. Although swaps are better suited for risks that involve multiple payments, at its most fundamental level, a swap is more or less just a series of forwards and, acknowledging the slight differences discussed above, more or less just a series of futures.

EXAMPLE 3 Forward Contracts, Futures Contracts, and Swaps

1. Which of the following characterizes forward contracts and swaps but not futures?

A. They are customized.

B. They are subject to daily price limits.

C. Their payoffs are received on a daily basis.

2. Which of the following distinguishes forwards from swaps?

A. Forwards are OTC instruments, whereas swaps are exchange traded.

B. Forwards are regulated as futures, whereas swaps are regulated as securities.

C. Swaps have multiple payments, whereas forwards have only a single payment.

3. Which of the following occurs in the daily settlement of futures contracts?

A. Initial margin deposits are refunded to the two parties.

B. Gains and losses are reported to other market participants.

C. Losses are charged to one party and gains credited to the other.

Solution to 1: A is correct. Forwards and swaps are OTC contracts and, therefore, are customized. Futures are exchange traded and, therefore, are standardized. Some futures contracts are subject to daily price limits and their payoffs are received daily, but these characteristics are not true for forwards and swaps.

Solution to 2: C is correct. Forwards and swaps are OTC instruments and both are regulated as such. Neither is regulated as a futures contract or a security. A swap is a series of multiple payments at scheduled dates, whereas a forward has only one payment, made at its expiration date.

Solution to 3: C is correct. Losses and gains are collected and distributed to the respective parties. There is no specific reporting of these gains and losses to anyone else. Initial margin deposits are not refunded and, in fact, additional deposits may be required.

This material completes our introduction to forward commitments. All forward commitments are firm contracts. The parties are required to fulfill the obligations they agreed to. The benefit of this rigidity is that neither party pays anything to the other when the contract is initiated. If one party needs some flexibility, however, it can get it by agreeing to pay the other party some money when the contract is initiated. When the contract expires, the party who paid at the start has some flexibility in deciding whether to buy the underlying asset at the fixed price. Thus, that party did not actually agree to do anything. It had a choice. This is the nature of contingent claims.