Question

Briefly explain:

       (a) What are the main shortcomings of the forward contracts?   

     (b) How are futures contracts designed to overcome these shortcomings?

Answer 1

The advantages are clear, the most obvious being you can stop things costing you more, or make sure you don’t lose out on foreign currency due at some point in the future.

• Buy now, pay later
• Lock in the current exchange rate for a future purchase/receipt
• Hedge your exposure and reduce your risk
• Very simple to set up
• Inexpensive to maintain
• You can draw down to get currency early
• You can rollover f you don’t need funds until after the original settlementThe main disadvantage is of course hindsight. One thing to bear in mind when looking at currency risk protection is that hedging can work against you. However, there are only a few disadvantages, compare to the protection that a currency forward provides.

• Forward and futures contracts are similar in many ways: both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset. A forward contract, though, is an arrangement made over-the-counter (OTC) between two counterparties that negotitate and arrive on the exact terms of the contract - such as its expiration date, how many units of the underlying asset are represented in the contract, and what exactly the underlying asset to be delivered is, among other factors. Forwards settle just once at the end of the contract. Futures, on the other hand, are standardized contracts with fixed maturity dates and uniform underlyings. These are traded on exchanges and settled on a daily basis.