CFA Level 1: Futures and Forward Contracts

Futures and Forward Contracts

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Question

Sally Ferguson, CFA, is a hedge fund manager. Ferguson utilizes both futures and forward contracts in the fund she manages. In speaking with a client, Ferguson makes the following statements to answer their questions about futures and forward contracts:

Statement 1:A futures contract is an exchange traded instrument with standardized features.

Statement 2:Forward contracts are marked-to-market on a daily basis to reduce credit risk to both counter parties.

Indicate whether Statement 1 and Statement 2 are most likely correct or incorrect.

Answers

Explanations

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A. B. C.

A

Statement 1: "A futures contract is an exchange traded instrument with standardized features."

This statement is correct. A futures contract is a type of derivative instrument that obligates the parties involved to buy or sell an underlying asset at a predetermined price and date in the future. Futures contracts are typically traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). They are highly standardized in terms of contract size, expiration date, and settlement procedures. The standardized nature of futures contracts allows for liquidity and ease of trading.

Statement 2: "Forward contracts are marked-to-market on a daily basis to reduce credit risk to both counterparties."

This statement is incorrect. Forward contracts are not marked-to-market on a daily basis. Unlike futures contracts, forward contracts are typically traded over-the-counter (OTC) and are not subject to daily mark-to-market valuations. In a forward contract, two parties agree to buy or sell an underlying asset at a future date and at a price determined at the time of the contract. The settlement of a forward contract occurs at the end of the contract term. The absence of daily mark-to-market valuations in forward contracts exposes the counterparties to credit risk, as the value of the contract can change significantly over time without any adjustments.

Therefore, the correct answer is:

B. Only Statement 2 is correct.

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