7.futures and forwards

8/12/2019 7.Futures and Forwards

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Futures and Forwards

By Gopal Bhatta

March 2009



2Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 2.2

Futures Contracts

Available on a wide range of underlyings

Exchange traded

Specifications need to be defined: – What can be delivered,

– Where it can be delivered, &

– When it can be deliveredSettled daily



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Futures Contract

A futures contract is an agreement between two partiesto buy or sell an asset at a certain time in the future fora certain price.

Unlike forward contracts,future contracts are normallytraded on an exchange.

To make trading possible, the exchange specifies

certain standardized features of the contract. As two parties to the contract do not necessarily knoweach other, the exchange also provides a mechanismthat gives the two parties a guarantee that the contract

will be honored.



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Background of Mechanics of Futures Markets

Future contracts are now traded actively all over theworld.

The largest Future exchanges in US – CBOT- www.cbot.com

– Chicago Mercantile Exchange- www.cme.com IN EUROPE – London International Financial Futures and Options

Exchange- www.liffe.com

– Eurex- www.eurexchange.com – Euronext- www.euronext.com

Others – Tokyo International Financial Futures Exchange-

www.tiffe.com

http://www.cbot.com/

http://www.cme.com/

http://www.liffe.com/

http://www.eurexchange.com/

http://www.euronext.com/

http://www.tiffe.com/

http://www.tiffe.com/

http://www.euronext.com/

http://www.eurexchange.com/

http://www.liffe.com/

http://www.cme.com/

http://www.cbot.com/



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The Specification of a Futures Contract

While developing a new contract, the exchangemust specify in some detail:

– The asset

– The contract size (exactly how much of the asset willbe delivered under one contract)

– Where delivery will be made – When delivery will be made



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The Asset

When the asset is a commodity, there may be a quitevariation in the quality of what is available in a marketplace. The New York Cotton Exchange has specifiedthe asset in its orange juice futures contract as:

US grade A, with Brix value of not less than 57 degrees,having a Brix value to acid ratio of not less than13 to 1nor more than 19 to 1, with factors of colors and flavoreach scoring 37 points or higher and 19 for defects, witha minimum score 94.

The financial assets in futures contract are generally welldefined and unambiguous.



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The Contract Size

The contract size specifies the amount of assetthat has to be delivered under one contract.

If contract size is too large, investors who wish totake small speculative position will be unable touse the exchange.

If contract size is too small, trading may beexpensive, as there is a cost associated witheach contract.



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The Contract Size

Some examples: – Corn: 5000 bushel (CBT, cents/bushel)

– Soybean Meal: 100 tons (CBT, $/ton)

– Soybean oil: 60,000 lbs (CBT, cents/lbs)

– Cattle-Feeder: 50,000 lbs (CME, cents/lbs)

– Gold: 100 troy oz, (CMX, $/troy oz)

– Japanese yen: 12.5 million yen (CME, $ per yen)

– British pound: 62,500 pound (CME, $/pound)

– DJIA: $10 times average (CBOT)

– S&P 500 index ($250 times average)



9Fundamentals of Futures and Options Markets, 6th Edition, Copyright © John C. Hull 2007 2.9

DeliveryIf a futures contract is not closed out before maturity, it isusually settled by delivering the assets underlying thecontract. When there are alternatives about what is

delivered, where it is delivered, and when it is delivered,the party with the short position chooses.

A few contracts (for example, those on stock indices and

Eurodollars) are settled in cash



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Delivery Arrangements

The where delivery will be made must be specified bythe exchange.

An example : CME’s random length lumber contract.The delivery location is specified as:

On track and shall either be unitized in double doorboxcars or, at no additional cost to buyer, each unit

shall be individually paper-wrapped and loaded onflatcars. par deliver of hem-fir in California, Idaho,Montana, Nevada, Oregon, and Washington, and in theprovince of British Columbia.



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Delivery Months

A futures contract is referred to by its deliverymonth.

The exchange must specify the precise periodduring the month when delivery can be made.

For many futures contracts, the delivery period is

the whole month.The exchange also specifies the last day onwhich trading can take place for a given contract.



13Fundamentals of Futures and Options Markets, 6th

Edition, Copyright © John C. Hull 2007 2.13

Margins

A margin is cash or marketable securitiesdeposited by an investor with his or her broker

The balance in the margin account is adjusted toreflect daily settlement

Margins minimize the possibility of a loss

through a default on a contract





Example of a Futures Trade

An investor takes a long position in 2December gold futures contracts on June 5 – contract size is 100 oz.

– futures price is US$400

– margin requirement is US$2,000/contract (US$4,000 intotal)

– maintenance margin is US$1,500/contract (US$3,000 intotal)





A Possible OutcomeTable 2.1, Page 27

Daily Cumulative Margin

Futures Gain Gain Account Margin

Price (Loss) (Loss) Balance Call

Day (US$) (US$) (US$) (US$) (US$)

400.00 4,000

5-Jun 397.00 (600) (600) 3,400 0. . . . . .. . . . . .. . . . . .

13-Jun 393.30 (420) (1,340) 2,660 1,340. . . . . .. . . . .. . . . . .

19-Jun 387.00 (1,140) (2,600) 2,740 1,260. . . . . .. . . . . .. . . . . .

26-Jun 392.30 260 (1,540) 5,060 0

+

= 4,000

3,000

+

= 4,000

<





Other Key Points About Futures

They are settled daily

Closing out a futures position involves

entering into an offsetting trade

Most contracts are closed out beforematurity





Convergence of Futures to Spot (Figure 2.1, page 25)

Time Time

(a) (b)

Futures

PriceFutures

PriceSpot Price

Spot Price





Regulation of Futures

Regulation is designed to protect thepublic interest

Regulators try to preventquestionable trading practices byeither individuals on the floor of the

exchange or outside groups





Accounting & Tax

It is logical to recognize hedging profits (losses)at the same time as the losses (profits) on theitem being hedged

It is logical to recognize profits and losses fromspeculation on a mark to market basis

Roughly speaking, this is what the accounting

and tax treatment of futures in the U.S.andmany other countries attempts to achieve



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Introduction to Forward Contract

A forward contract gives the owner the right andobligation to buy a specified asset on a specified date ata specified price.

The seller of the contract has the right and obligation tosell the asset on the date for that specified price.

At delivery, ownership of good is transferred andpayment is made.

The agreement is made today to exchange cash for agood or service at a later date.

In a spot transaction, one party pays for a good orservice, and immediately receives that good or service.





Forward Contracts

A forward contract is an OTC agreementto buy or sell an asset at a certain time inthe future for a certain price

There is no daily settlement (unless acollateralization agreement requires it). Atthe end of the life of the contract one party

buys the asset for the agreed price fromthe other party





Profit from a Long Forward or

Futures PositionProfit

Price of Underlying

at Maturity





Profit from a Short Forward or

Futures PositionProfit

Price of Underlying

at Maturity



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Futures vs. Forwards

Futures are standardized, Forwards custom madecontracts.

Futures are more liquid than forwards.Counter party risk is higher in forwards than in futures.

Most futures contract are eventually offset where asmost forward contract terminate with delivery of the

specific good.While profits or losses on forward contracts are realizedonly on the delivery day, the change in the value offutures contract results in a cash flow every day. Less

default risk with futures contract.



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Forward Contracts vs FuturesContracts (Table 2.3, page 39)

Forward Futures

Private contract between two parties Traded on an exchange

Not standardized Standardized

Usually one specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final settlement usual Usually closed out prior to maturity

Some credit risk Virtually no credit risk

Fundamentals of Futures and Options Markets, 6th




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Forwards:General Concepts

Two parties:

– Buyer: agrees to buy something in future, Long position

– Seller: Obligation to sell something in future, Short positionDelivery date

– The terms of the contract are agreed upon today, anddelivery and payment take place in the future, what is called

delivery date, or settlement date or Maturity date. – The buyer agreed to take delivery and seller agreed to make

delivery.



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Forwards:General Concepts (2)

Money rarely changes hands when a forwardcontract is originated.

However, one or both of the parties may demand“good faith” money to serve as collateral thatbacks up the obligations stated in the contract.

Payment from the buyer of the forward contractto the seller is generally made only upon thedelivery of the good.



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Most business transactions are actually forwardtransactions.

A firm might order 10,000 widgets from another firm.The price is agreed upon today. No cash flows occurtoday.

The widgets will be delivered one month hence.

Payment is not made until after the widgets have beenreceived.

For all practical purposes, this is a forward contract.



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The failure of a party to do what has been agreed to, asstated in the contract, is known as default.

On the day that a forward contract is originated, bothparties face possible default risk: the future uncertaintyconcerning the other parties ability and/or willingness tofulfill the terms of the contract.

Penalties for failing to fulfill the terms of forwardcontracts vary, however, in business default is seriousmatter that will likely to lead to legal action.



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Forward price is the specified price in forward contractto be paid in future specified date. It differ from spotprice which is today's price for delivery.

A fair forward price will result in a forward contract thathas no value when it is originated.

The equilibrium forward price is a fair price in the sense

that the demand for forward contracts equals the supplyof forward contracts at that forward price.

The value of a forward contract at that fair forward priceis zero.



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Forward contracts, like all derivatives, are zero sumgames. Whatever one party gains, the other party must

lose.The profit and losses associated with forward contractsare typically realized at delivery.

Before delivery, as forward prices for delivery on the

settlement date of the original contract fluctuate, eachparty could experience unrealized gains and losses.



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Let us define the following: – origination date of the forward contract = time 0

– Delivery date of the forward contract = time t

– forward price on origination date of the forward contract =

F(0,T) – the spot price on the deliver date = S(T)

– The actual profit or loss for the party that is long the forwardcontract is then S(T) – F(0,T) per unit of the good undercontract.

– The actual profit or loss for the party that is short the forwardcontract is the same amount, but the opposite sign: F(0,T) -S(T).

– Many forward contracts are cash settled. No delivery takes

place on the settlement date.



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It was stated that when a forward contract is originated,it has no value.

At subsequent times, it will almost surely have positivevalue for one party and negative value for the otherparty.

When a forward contract becomes an asset (haspositive value) for one party, that party will become

concerned about the default risk or performance orcredit risk of counter party.

At a point in time only one party, the one for which theforward contract is an asset, will worry about current

default risk.



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Convergence of Futures Price to Spot Price

As the delivery period for a futures contract isapproached, the futures price converges to the

spot price of the underlying assetWhen the delivery period is reached, the futuresprice equals –or is very close to- the spot price.

If futures price is above or below the spot price,there exist an arbitrage opportunity.



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The Clearing House

Each futures exchange has an associated clearinghouse that becomes the “seller’s buyer” and the

“buyer’s seller” as soon as a trade is concluded. When investors (long and short trader) reach in theiragreements though their brokers in exchange, theclearing house will immediately step in and break the

transaction apart.The clearing house is in potentially risky position ifnothing regarding the margin requirements are done.



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Initial Margin

In order to buy and sell futures contract, an investormust open a futures account with a brokerage firm.

Whenever a futures contract is signed, both buyer and

seller are required to post initial margin, i.e.makesecurity deposits that are intended to guarantee that willin fact be able to fulfill their obligations.

the amount of this margin is roughly 5-15% of the total

purchase pricethis deposit can be made in the form of either cash orcash equivalents, or a bank line of credit, and it formsthe equity in the account on the first day.

Initial margin does not provide complete protection.



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Marking to Market (2)

An Example;

A July wheat contract future for 5000 bushels at $5 perbushel cost $20,000. Initial margin is $1000.

B is buyer and S is seller.In day 2, the settlement price of July wheat is $4.10.

B gains $500 and S lost $500 on day 2.

S has the equity of $500 and B has equity of $1500 in

day 2.In day 3, the settlement price of July wheat had fallen to$3.95.

B’ account dropped to $750 and S’s equity has risen to$1,250.



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Maintenance Margin

The investor must keep the account’s equity equal to orgreater than a certain percentage of the amountdeposited as initial margin (roughly > or =65% of initial

margin).If this requirement is not made, the investor will receivea margin call from his or her broker.

The call is a request for an additional deposit of cashknown as variation margin to bring the equity up to theinitial margin level.

If the investor does not respond , then the broker will

close out the investor’s position by entering a reversingtrade in the in the investor’s account.



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Closing Out positions

The vast majority of futures contracts do not lead todelivery. The reason is that most traders choose toclose out their positions prior to the delivery period

specified in the contract.Closing out a position means entering in to the oppositetype of trade from the original one.

Once the reversing trade has been made, the trader willbe able to withdraw money from his equity account.

Delivery is so unusual that traders sometime forget howthe delivery process works.

7.futures and forwards

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