A Comparison of Futures, Equities, Forwards
and Over-the-Counter Derivatives

Futures have a number of characteristics in common with equities, forward contracts and over-the-counter (OTC) derivatives, as well as a number of dissimilarities. A comparison of these financial instruments is useful to understand the purposes and functions of futures contracts.

Futures and Equities

Important differences between futures and equities include:

• Purpose--futures markets exist to facilitate risk shifting and price discovery; the principal purpose of equities markets is to foster capital formation.

• Short positions--in futures trading there is a short for every long; in equities markets, short positions are normally a minor factor. In addition, establishing a short position in a futures market is no more difficult than establishing a long position. In contrast, a short position in equities requires owning or borrowing the securities and payment of dividends.

• Margin--the customer funds deposited to carry a futures position are a performance bond or good faith money, securing the promise to fulfill the contract's obligations. Typically, futures positions are marked to market on a daily basis, and no interest is charged to maintain a futures position. In margined stock purchases, the margin acts as a down payment, and the balance of the purchase price is borrowed, with interest charged. There is no daily marking to market in the equities markets, but if prices change by a significant amount a maintenance margin call is made.

• Maturity--the life of a futures contract is limited to its specified expiration date; most equities are issued without a termination date.

• Price and position limits--a price limit on a futures contract establishes the maximum range of trading prices during a given day. A futures position limit establishes the maximum exposure a market participant may assume in a particular market. Many futures markets have price and/or position limits. Equities typically do not have limits on price movements or the size of positions.

• Supply--while the outstanding number of equities is fixed at a given moment, there is no theoretical limit on the number of futures or options on futures that may exist at a particular time in a specific market.

• Ownership record--unlike equities, where a customer can ask a broker for a certificate that evidences ownership, there are no comparable certificates for futures or options on futures. A customer's written record of a futures position is the trade confirmation received from the brokerage house through which the trade was made.

• Market-making system--open-outcry futures markets typically operate with a multiple market-maker system, involving floor traders and floor brokers competing on equal footing in an auction-style, open-outcry market. Equities markets typically operate with a specialist system, where the designated specialist has specified privileges and responsibilities with respect to a given stock, although non-specialist brokers also may compete for trades.

A forward contract can be considered a customized futures contract. A forward is an agreement between two parties to buy or sell a commodity or asset at a specific future time for an agreed upon price. Typically, the contract is between a producer and a merchant; two financial institutions; or a financial institution and a corporate client. Historically, forward contracts developed as customized instruments involving delivery of an underlying commodity or financial instrument.

Important distinctions between forward and futures contracts include:

• Contract guarantee--the performance of futures and options on futures contracts is guaranteed by the clearinghouse of the exchange on which the contracts are executed. Because no such clearinghouse exists for forward contracts, participants must pay particular attention to counterparty creditworthiness.

• Cash flows--exchange-traded contracts involve daily payments of profits and losses via a mark-to-market margining system, while forward contracts generally do not involve daily or other periodic payments of accumulated gains or losses. As a result, large paper losses and gains may accumulate with forward contracts and increase the likelihood and cost of a default. Alternatively, depending upon the creditworthiness of the counterparties and the magnitude of the exposure, parties to forward contracts may be required to post collateral and/or make periodic payments against accumulated losses.

• Contract terms--futures contracts are standardized; forward contracts are created on a customized basis, with terms such as the grade of the underlying commodity or asset, delivery location and date, credit arrangements and default provisions negotiated between and tailored to the needs of the two parties.

• Liquidity--in the absence of standardized contracts and a large number of buyers and sellers, forward markets often lack the low transaction costs and ease of entry and exit found on liquid exchange markets.

Over-the-counter derivatives encompass tailored financial instruments, such as swaps, swaptions, caps and collars, that are traded in the offices of the world's leading financial institutions. OTC derivatives are similar to forward contracts that have been used by commercial enterprises for over a century; each of the previously mentioned distinctions between futures and forwards discussed above also applies to a comparison of futures and OTC derivatives. As with forwards, the growth of OTC derivatives trading has been fostered by the existence of liquid futures and options on futures exchange markets in which the risks of the customized OTC instruments can be transferred to a broader marketplace.