Terminating a Forward Contract Prior to Expiration

CFA Level 1 - Derivatives

Parties to a futures contract may also terminate the contract prior to expiration through an offset. Offset is the transaction of a reversing trade on the exchange. If you are long 20 March soybean futures traded on the Chicago Board of Trade, you can close the position by taking an offsetting short position in 20 March soybean contracts on the same exchange. There will be a final margining at the end of the day, and then the position will be closed. In other words, if you buy a futures contract and subsequently sell a comparable contract, you have offset your position and the contract is extinguished. Offset trades must match in respect to the underlying asset, delivery dates, quantity, etc., or the original position will not be effectively terminated. In such cases, price movements in the original contract will continue to result in gains or losses. 

Compare this to the forward market wherein if you buy a forward contract and then sell an identical forward contract you are left with obligations under two contracts - one long and one short

Default Risk and Early Termination
Default risk on early termination only applies to forward contracts because there is no default risk on futures. (As we stated earlier, futures trades made on a formal exchange are cleared through a clearing organization, which acts as the buyer to all sellers and the seller to all buyers. The clearing house acts as a counterparty, guaranteeing delivery and payment and nullifying any default risk.) 

Forward contracts are negotiated agreements between buyer and seller. To enter into a forward contract, it is necessary to find someone who wants to buy exactly what you want to sell when and where you want to sell it. Without a formal exchange and clearing house to guarantee delivery and payment, there is always a chance that either the buyer or the seller will default on an obligation. If one of these counterparties fails, the other is still responsible for performing under the contract. Traders in forward contracts who re-enter the market to execute a reversing trade prior to the expiration date will effectively increase their default risk exposure because they will be dealing with two different counterparties, both of which have to live up to their ends of the bargain. To extinguish default risk on a forward contract, a trader must place the reversing position with the samecounterparty and under the same terms as in the originally contract. Obviously, this makes it difficult to get out of a forward contract prior to termination. 

| | Print This! | No comments

Do you like this post?