How Level I tests futures versus forwards, daily settlement, swap structure, and basic rate-contract valuation logic.
Level I next asks you to separate forward-like contracts that look similar on the surface but behave differently in practice. Futures and swaps are both forward-commitment instruments, but settlement mechanics, standardization, and valuation framing matter.
Candidates often miss these questions because they:
The stronger reader keeps the contract mechanics tied to the valuation logic.
| Feature | Forward | Futures | Why Level I cares |
|---|---|---|---|
| Trading venue | Usually OTC | Usually exchange-traded | Helps identify customization versus standardization |
| Settlement | Typically at expiration | Marked to market daily | Daily cash settlement changes the economics |
| Counterparty exposure | Bilateral | Reduced by clearinghouse and margining | Counterparty risk differs |
| Flexibility | High | Lower | Users trade off customization against liquidity and security |
The daily settlement feature is the main reason a futures price may not exactly match a comparable forward price.
If gains on a futures position are realized sooner through daily settlement, the economic result depends on what happens to interest rates when the futures price moves.
| Situation | Likely implication |
|---|---|
| Underlying price gains tend to arrive when rates are high | Futures can become more attractive because gains are reinvested at better rates |
| Underlying price gains tend to arrive when rates are low | Futures may be relatively less attractive |
Level I is usually testing the intuition, not a full quantitative derivation.
An interest rate swap can be viewed as a sequence of future exchanges, often one side fixed and the other floating. That is why the curriculum says swaps are similar to but different from a series of forwards.
| Swap feature | What it means |
|---|---|
| Series of exchanges | Multiple settlement dates rather than one terminal settlement |
| Netting of cash flows | Often only the net difference is exchanged |
| Fixed versus floating structure | The contract reallocates interest-rate exposure between parties |
This is enough to answer most Level I swap-structure questions correctly.
At initiation, the fixed rate on a swap is typically set so that the swap’s value is zero to both parties. Later, value changes as market rates move.
A simple valuation identity is:
$$ V_{\text{swap}} = PV(\text{receive leg}) - PV(\text{pay leg}) $$
That one line captures most of what Level I wants from you conceptually.
| Position | Generally benefits when |
|---|---|
| Pay fixed, receive floating | Market fixed rates rise after initiation |
| Receive fixed, pay floating | Market fixed rates fall after initiation |
The exam may phrase this indirectly by describing how the market swap rate changed after the contract was entered.
Whether the contract is a forward rate agreement, a futures contract, or a swap, the core question is the same:
Level I likes to test this as interpretation before computation.
A candidate says a pay-fixed interest rate swap loses value whenever rates rise because fixed cash flows become less valuable. That mixes bond intuition with swap position logic. A stronger answer asks what the contract now offers relative to the market fixed rate for a new swap.
That is typical Level I design: compare the old contract with the new market terms.
Why can a futures contract have a different price from an otherwise similar forward contract?
Best answer: Because daily marking-to-market changes the timing of gains and losses, and that timing matters when interest rates interact with price movements.
Why: Level I tests the settlement-mechanics intuition more than advanced modeling detail.