Hi all,
As far as i knew these 2 were relatively similar except for credit risk and mark to market. But why is it that some commodity thedgers often prefer forwards, saying that there is no basis risk...? isint there basis risk in forwards as well?
thanks
BP
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Well, if you were looking to buy a specific type of crude that doesnt have a futures contract, then you'd be subject to basis risk if you were to simply buy WTI futures. However, if you find a guy that produces the type of crude you need, then a forward contract with him would not have such a commodity mismatch. But if you still went with a WTI forward contract, then you subject yourself to basis risk, since you need a slightly different grade of crude.
Of course, credit risk prevails in any forward contract.
Hope that answers the question.
YGS, it's way simpler than that. Futures are standardized and processed via clearing houses which lowers their default chances to zero. On the other hand, forwards are the result of private agreements, nobody is going to guarantee for that, hence why they are used for different purposes and closed in different ways.
Im talking about wanting to hedge wti forexample. Why does a forward on wti have less basis risk than a future?
Anyone?
Hegel - you are right, but that wasnt his question.
I just looked through my derivs class notes. Found the answer. With futures, you are marking to market the gains and losses along the way on a nominal basis, so you need less futures than forwards to get the same hedge. It is called tailing.
PM me if you want those lecture slides.
There are further differences between futures and forwards that are more subtle but arguably even more important from a practitioner's point of view, not just credit risk and MtM.
First of all, credit risk of forwards is complex because forwards are typically subject to various collateral pledging agreements. Yes, for futures the pnl is daily MtM at exchange settlement px but for forwards collateral is also exchanged. Credit risk mitigation for forwards is one of the least academically understood topics out there.
Here's an example. I can tell you that vast fortunes (approaching 10 figures) were made (and lost) in 2008 arising from the difference between collateral requirements for forwards and futures on the Nikkei index. Any guesses why? If you can think of a good reason why a Nikkei OTC forward might trade at a higher or lower price than an equivalent exchange-listed future, then you will definitely impress your professors/any derivatives trader.
Just a wild guess, I haven't taken any classes on this - does the discount/premium result from differences in the credit rating of the counterparty vs. the exchange/clearinghouse? Edit: or not necessarily "credit rating," maybe "credit worthiness" or something would be a more appropriate term? Did it have something to do with the underlying value of the collateral?
Gonna take a couple of stabs -
Forwards can have various collateral agreements depending on the counterparty, so not necessarily cash or in the same currency, which means some securities can be funded at a cheaper rate and posted as collateral?
LIBOR vs. TIBOR discounting?
Very good BiilyVanBarzini!
Think about what the USD / JPY basis swap would tend to do during a global financial crisis.
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