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With a forward, one’s exposure might be allowed to grow for the entire term of the contract, potentially resulting in a staggering debt for the losing party. Not so with futures contracts, which are nearly devoid of the extreme credit risk inherent to forwards. Daily settlement also has a subtle effect on futures prices as compared with otherwise identical forward prices, and a dramatic affect on their comparative valuation. As mentioned earlier, a futures price—the guaranteed price at which the long party must buy and short party must sell—is intuitively the same as an otherwise identical forward price when a contract is executed.

Then at five months, the price drops back to around $62, and so on. The price follows no predictable pattern whatsoever. In financial parlance, a price path like this is known as a random walk. In fact, one of the basic tenets in the land of derivatives is that all price paths are random walks. All About Derivatives 40 FIGURE 5-2 Sample Stock Price Path Imagine we are at time 0. Of course, we cannot know the future price path of ZED, because it’s unpredictable. Now imagine three different European call options on ZED all expiring in six months and having three different strike prices: $60, $62, and $64.

In Chapter 8, “Pricing Forwards and Futures,” we’ll see an example intended to make this clear. LIQUIDITY RISK While an exchange provides liquidity by always having buyers for prospective sellers and vice versa, some contracts are more liquid than others. And the liquidity for a given contract can change over time. This leads to liquidity risk, which is simply the chance that you may not find a trading opportunity at a desirable price when you are ready to get out of a position. ” Or when both supply and demand are comparatively low, trading activity decreases, bids 28 All About Derivatives (the price at which you can sell) tend to be low, and offers (the price at which you can buy, also known as an ask) tend to be high.