Differences between Swaps, Forwards and Futures

Among financial derivatives there are several instruments that may seem similar, but can potentially result in significant losses if not properly distinguished from each other. Swaps, Forwards and Futures are an example of this. They all have in common that they can be used to help organizations and individuals to hedge against risks. Another thing they have in common is that they are now all making their way to Bitcoin markets. With Swaps and Futures already covered extensively before, the below will quickly recap the definitions.

Definitions

A Swap contract is a contract in which parties agree to exchanging variable performance for a certain fixed market rate. In short, parties agree to exchanging cash flows on a future date. For Bitcoin this can either be fixed-floating commodity swaps or commodity-for-interest swaps

Futures Contracts or simply Futures are nothing more than an agreement between two parties to buy or sell a certain commodity (or financial instrument) at a pre-determined price in the future. Positions are settled on a daily basis.

Also Forwards come down to making an exchange at a future date. The agreements include delivering a certain amount of goods (or financial instruments) by the end of a certain period.

Futures and Forwards

The definitions should make clear why there can be confusion surrounding these derivatives. Every contract type involves an agreement to make an exchange at a certain pre-defined future date. Given the nearly identical description, Futures and Forwards are the most similar contracts. The key difference is in the fact that Futures are settled on a daily basis and Forwards are not.

Assume a farmer and a bread maker agree to exchange 5,000 bushels of wheat at $4 per bushel in June, equal to a total value of $20,000. The current price is also $4 per bushel. The farmer is the seller and thus has a short position, while the bread maker is the buyer and therefore has a long position. If the actual price of grain per bushel rises to $5 by the end of the contract, it would mean a loss of $5,000 to the farmer. On the other hand, the bread maker will have a profit of $5,000. This is the final outcome for both the Forward and Futures contract.

The big difference is in the daily adjustments in the Futures. If prices move to $5 per bushel the next day, then the gains and losses would be immediately credited or deducted. This is why margin requirements apply for Futures trading. For Forwards, nothing happens until maturity. Therefore, the intermediate gains and losses can never be greater than the final value.

If prices would move to $6 per bushel before the end of the Futures Contract, the farmer would see $10,000 deducted from his account while the bread maker would receive $10,000. Even if the price ends at $5 per bushel, the farmer will have to meet the margin requirements while the price is at $6 per bushel. This is why Futures Contracts mean increased liquidity risks compared to Forwards, where only the final value matters. If the farmer cannot meet the margin requirements, his positions could be force-closed and leave the farmer with a bigger realized loss then would otherwise be the case.

Because there is no daily settlement in Forwards, there is less such liquidity risk but increased counterparty risk instead. Margin requirements provide a guarantee that the counterparty will able to pay by the end of the contract, as accounts are adjusted every day. Forward contracts are typically negotiated directly between two parties as a result, while Futures are suitable to be quoted and traded on exchanges in standardized form.

Swaps and Forwards

A Swap contract compares best to a Forward contract, although a Forward has only a single payment at maturity while a Swap involves a series of payments in the futures. In fact, a single-period Swap is equivalent to one Forward contract. To prove this, consider a single period Swap maturing in June with a fixed price of $4 per bushel. The farmer in the previous example could take a long position in the Swap, meaning the fixed price would be receive while a floating (variable) performance has to be paid to the bread dealer. When the price per bushel increases to $5, the farmer will receive the fixed amount of $20,000. At the same time, the farmer would have to pay $25,000 to the bread dealer. Identical to the Forward, the farmer has lost $5,000 on the contract while the bread dealer has won $5,000.

Conclusion

Even though a farmer and bread maker were used for the example, all the same principles apply to similar Bitcoin derivatives (note that all contracts are typically cash settled). Bitcoin Futures can already be traded, and with the coming of cryptocurrency 2.0 other financial derivatives can also potentially be replicated, making them more accessible. Anyone hedging or speculating using these instruments should therefore be aware of the differences between them.