lecture 4 - futures and forwards - markets, basic

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Lecture 4: Futures and Forwards:

Markets, Basic Applications, and Pricing Principles

Dr. Nattawut Jenwittayaroje, CFAFaculty of Commerce and AccountancyChulalongkorn University

01135531: Risk Management and Financial Instrument

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A forward contract is an agreement between two parties in which one party, the buyer (long), agrees to buy from the other party, the seller (short), something (i.e., underlying asset) at a later date (i.e., maturity date) at a price agreed upon (i.e., delivery or forward prices) today

Exclusively over-the-counter The contract is an over-the-counter (OTC) agreement between 2

companies No physical facilities for trading OTC market consisting of direct communications among major

financial institutions

Forward Contracts

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Futures Contracts Similar in principle to forward contracts, but a futures contract is

traded on an exchange, while a forward contract is traded OTC.

the contracts are standardized and specified by the exchange, makingtrading in a secondary market possible.

Give up flexibility available in forward contacting for the sake ofliquidity.

Forward contracts: the terms of the contract (contract size, maturitydate, and etc.) can be tailored to the needs of the traders.

Virtually no credit risk – Futures exchanges provide a mechanism(known as the clearinghouse) that guarantee that the contract will behonored. For forwards contracts, creditworthiness of the seller isimportant.

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Forward Contracts Versus Futures

Forward contracts

Trade on OTC markets

Not standardized

Specific delivery date

Settled at end of contract

Delivery or final cashsettlement usually takesplace

Futures

Traded on exchanges

Standardized contract

Range of delivery dates

Settled daily (by dailymarking to market)

Usually closed out prior tomaturity

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Derivatives Markets in Thailand Thailand Futures Exchange pcl. (TFEX)

SET 50 Index Futures

Single Stock Futures

• For example, ADVANC, PTT, and PTTEP

Gold Futures, Silver Futures, and Brent Crude Oil Futures

USD Futures

Interest Rate Futures

SET 50 Index options

• Call options

• Put options

Agricultural Futures Exchange of Thailand (AFET)

Futures contracts on Natural Rubber Ribbed Smoked Sheets No 3

Futures contracts on White Rice 5% Both Options

Futures contracts on Tapioca Chip 66

SET50 Index Futures Contract

Specifications

www.tfex.co.that 21 Mar 13

77

www.tfex.co.that 21 Mar 13

Single Stock Futures Contract

Specifications

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The Specification of Futures ContractsUnderlying asset Particularly for commodity futures, the exchange sets allowable grade

of a commodityDelivery location Place and means of deliveryContract size, e.g. For a crude oil futures contract, 1,000 barrels For the Dow Jones stock index futures, $10 per index point For the SET50 index futures, Baht1,000 per index point For a Eurodollar futures contract, $1 million of a Eurodollar time

depositQuotation Specify how a price of a futures is quoted. E.g. for the CBOT’s corn

futures, prices are quoted in cents per bushel

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The Specification of Futures ContractsDelivery months (expiration months)

The main delivery months for futures are March, June,September and December.

Deliverable or cash settlement contracts

Deliverable contract: settled by delivery of the item

Cash settlement: settled by the payment of cash

Daily price movement limits

Prevent large price movement from speculators.

Position limits

Prevent speculators from having big influence on the market

The max. no. of contracts that an investor may hold.

1010

TFEX’s SET 50 Index Futures

Settlement price (SP): this usually is an average of the prices of the last fewtrades of the day. The settlement price is used to mark-to-market the position.

Volume: A number of contracts traded

Open interest (OI): The number of futures contracts outstanding at any givenin time.

www.tfex.co.th at 13 Jan 2014SET 50 index spot = 880.7

1111

TFEX’s Gold & Single Stock Futures

Gold spot = 19,450

KTB spot = 16.501212

TFEX’s USD and Brent crude Futures

USD spot = 33.02 www.bot.or.th

Brent spot = 106.77*33.02 = 3,525

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AFET’s Futures

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Example of Futures Listing on CBOT

15 16

สินคาอางอิง ทองคําแทงที่มีความบริสุทธิ์ 96.5%

ขนาดของสัญญา 1 สัญญามีขนาดเทากับ ทองคําน้ําหนัก 50 บาท

เดือนที่สัญญาสิ้นสุดอายุ เดือนคู (ก.พ., เม.ย., มิ.ย., ส.ค., ต.ค., ธ.ค.) ใกลที่สุด 3 ลําดับ

ชวงราคาซื้อขายขั้นต่ํา 10 บาท ตอ 1 สัญญา

ชวงการเปลี่ยนแปลงของราคาสูงสุดแตละวัน ไมเกิน + 20 % ของราคาที่ใชชําระราคาในวันทําการกอนหนา

เวลาซื้อขาย Pre-open : 9:15 - 9:45Morning : 9:45 - 12:30 Pre-open : 14:00 - 14:30 Afternoon: 14:30 - 16:55

ราคาทีใ่ช้ชําระในวนัสุดท้าย วันทําการกอนวันทําการสุดทายของเดอืนที่สัญญาสิ้นสุดอายุ โดยในวันนั้น สัญญาที่จะหมดอายุจะซื้อขายไดถึงเวลา 16.30 น.

Gold Futures

1717

ราคา Gold Spot13 มค. 2557

ราคา Gold Futures13 มค. 2557

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กราฟแสดงราคาทองคาํspot กบั ราคาทองคาํฟิวเจอร์ส

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เปรียบเทียบทองคาํ (spot) กบั โกลดฟ์ิวเจอร์ส (futures)ทองคาํ โกลดฟวเจอรส

เงินลงทุน ชําระเงินเต็มมลูคา วางเงินค้ําประกันประมาณ 10%

การสงมอบสินคา สงมอบจริง ชําระเปนเงินสด

กลยุทธการทํากําไร ทํากําไรไดเฉพาะขาขึ้น ทํากําไรไดทั้งขาขึ้นและขาลง

ราคาซื้อขาย ประกาศโดยสมาคมผูคาทอง เปลี่ยนแปลงตลอดวนัตามการซื้อขายในตลาด

ระยะเวลาการลงทุน ระยะกลาง-ยาว ระยะสั้นวันตอวนั

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การทาํกาํไรในตลาดขาขึ้น

กาํไร = 199,000 – 196,000 = 3,000 เงินลงทุน 15,000 กาํไรร้อยละ 20%

ซื้อ มูลคา

196,000

ขาย มูลคา

199,000

เงนิประกนั

GFM10

19,600

19,900

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การทาํกาํไรในตลาดขาลง

กาํไร = 196,000 – 192,500 = 3,500 เงินลงทุน 15,000 กาํไรร้อยละ 23%

ซื้อ มูลคา

192,500

ขาย มูลคา

196,000

GFM10

19,250

19,600

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Clearinghouse The futures exchange provides a clearing mechanism.

Without a clearinghouse, traders will face a counter-partyrisk

With clearing house, each trader only has an obligation withthe clearinghouse

The clearinghouse becomes

The seller of the contract for the long position

The buyer of the contract for the short position

The clearinghouse’s position nets to zero

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Clearinghouse

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Clearinghouse

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Margin Account Since each trader has an obligation with the exchange, and futures

contracts expose to risk of loss.

To protect the exchange from a possible loss on a futures contract, theexchange requires each trader to deposit an initial margin.

The initial margin (deposit) is usually required between 5% to 15% ofthe total value of the contract. For example, for SET50 index futures, theinitial margin is 85,000 per contract, or about 85,000/(1,000*880) = 10.4%.

During the life of a contract, the trader must maintain their accountabove maintenance margin level, e.g., 5% of the total value of thecontract. For SET50 index futures, the maintenance margin is 60,000 percontract, or about 60,000/(1,000*880) = 6.8%.

When falls below the maintenance level, they will receive a margincall and is requested to top up the margin account to the initial marginlevel.

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Daily Settlements (Marking to Market) Furthermore, the profit/loss on a futures contract is settled daily. Winning party

The surplus (above initial margin) from its account can bewithdrawn.

Otherwise, interest is paid on the funds left in this account. Losing party

Additional payments if the value of the position falls belowmaintenance margin

Marking to market can be more than one time per day (i.e.,Intra-day margin call)

For a forward contract, the profit/loss is realized and settled onlyonce at the maturity.

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Example Suppose that the SFE SPI 200 index futures contract is now

traded at 3,500 index points. Its contract size is $25 per indexpoint. The initial and maintenance margins for each contractare 10% and 5% of the value of the contract respectively.

Initial margin = 10% $87,500 (3,500$25 ) = $8,750

Maintenance margin = 5% $87,500 (3,500$25 ) = $4,375

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Day FuturePrice

Daily gain/loss Margin account balance for SHORT positions

Margin call

0123

3,5003,6003,7003,650

-100×25= -$2,500-100×25= -$2,500

50×25= $1,250

$8,750$6,250$3,750

$1,250+$8,750=$10,000

-$5,000

-

Day FuturePrice

Daily gain/loss Margin account balance for LONG positions

Margin call

0123

3,5003,6003,7003,650

100×25= $2,500100×25= $2,500-50×25= -$1,250

$8,750$11,250$13,750$12,500

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Closing Out Positions (Reversing Trading) A trader can close out a position at anytime before the

settlement date. Closing out a long position

taking an a short position on the same contract. A trader bought a June interest rate future contract at 3,200. If in April, the interest rates futures are traded at 3,300. this

trader can close out the position and realise the profit byselling (shorting) the contract.

Closing out a short position taking a long position on the same contract.

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Closing Out Positions and Open Interest The number of contracts outstanding (i.e. number of either

long or short contracts outstanding)

Almost all traders (i.e., about 99%), however, liquidate (i.e.,closeout) their positions before the contract maturity date.

Futures contracts rarely result in actual delivery of theunderlying asset.

The fraction of contracts that result in actual delivery isestimated to range from less than 1 to 3%, depending onthe commodity and the activity in the contract.

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Day FuturePrice

Daily gain/loss Margin account balance for SHORT positions

Margin call

01234

3,5003,6003,7003,6503,600

-100×25= -$2,500-100×25= -$2,500

50×25= $1,25050×25= $1,250

$8,750$6,250$3,750

$1,250+$8,750=$10,000$11,250

-$5,000

-

Day FuturePrice

Daily gain/loss Margin account balance for LONG positions

Margin call

0123

3,5003,6003,7003,650

100×25 = $2,500100×25 = $2,500-50×25= - $1,250

$8,750$11,250$13,750

$12,500 - $12,500

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3,6503,600 -50×25 = -$1,250

$9,125$7,875

The old LONG trader sells the futures contract to a new LONG trader.

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Forward Contracts Versus Futures

Forward contracts

Trade on OTC markets

Not standardized

Specific delivery date

Settled at end of contract

Delivery or final cashsettlement usually takesplace

Futures

Traded on exchanges

Standardized contract

Range of delivery dates

Settled daily

Usually closed out prior tomaturity

The clearinghouse and margin account show how daily settlement and closing-out positions work

33

Open Interest and Volume Consider the following example on how to compute open interest and volume.

Time Trading Activity Open Interest

Volume Who are in the market?

Jan 1 A buys 1 futures contract and Bsells 1 futures contract

1 1 A(+1) : B(-1)

Jan 2 E buys 1 futures contract and Asells 1 futures contract

Jan 3 B buys 1 futures contract and Esells 1 futures contract



Jan 1 A buys 1 futures contract and Bsells 1 futures contract

1 1 A(+1) : B(-1)

Jan 2 C buys 2 futures contracts and Dsells 2 futures contracts

Jan 3 B buys 1 futures contract and Dsells 1 futures contract 34

Open Interest and Volume Consider the following example on how to compute open interest and

volume.



Jan 1 A buys 1 futures contract and B sells 1 futures contract

1 1 A(+1) : B(-1)

Jan 2 C buys 10 futures contracts and D sells 5 futures contracts and E sells 5 futures contracts

Jan 3 B buys 3 futures contracts and A sells 1 futures contract and C sells 2 futures contracts

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Speculating using Futures and Leverage A crude oil futures contract calls for delivery of 1,000 barrels of

oil. The current future price for delivery in May is $67.15 perbarrel. Suppose the initial margin requirement for the oil contractis 10%.

Expect crude oil prices are going to increase Long oil futures Initial margin = 10%$67,150 ($67.15 1,000 ) = $6,715 If the price of the oil futures increase by $2 ($2/$67.15 = 2.98%) create the gain to the long futures = $21,000 = $2,000 or

2,000/6,715 = 29.8%

Leverage: Ability to take on relatively large exposure to the marketusing futures and options for a relatively small initial outlay.

The 10-to-1 ratio of % change reflects the leverage inherent in the future position.

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Hedging using futuresShort hedges

It is a hedge that involves a short position in futurescontracts

It is used when the hedger already own an asset andexpects to sell it at some time in the future.

Long hedges

It is a hedge that involves a long position in futurescontracts

It is used when the hedger knows it will purchase a certainasset in the futures.

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Example: Hedging using Futures Consider an oil distributor (i.e. hedger) plans to sell 100,000

bbls of oil in May that wishes to hedge against a possibledecline in oil prices. Each oil futures contract calls fordelivery of 1,000 bbls of oil. F0 = $67.15 per barrel.

Hedging strategy: short 100 oil futures contracts

Consider 3 possible spot prices (ST) of oil in May.

- When the spot price (ST) in May is low, the low revenue from spot contract is offset by the profit from the short futures positions- When pt is high, the high revenue is offset by the loss from the short futures.- All cases, end up 6,715,000: elimination risk: uncertain of the spot price.

F0 -ST

ST

ST

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Example: Hedging using Futures

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Forwards/Futures – pricing principle

Should there be any relationship between spot and forward/future prices?

Is forward/futures price a consensus expected spot price at maturity?

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1. Gold: An Arbitrage Opportunity? Suppose that:

The spot price of gold is US$900 The 1-year futures price of gold is US$960 The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?Action at time 0 Initial Cash

FlowCash Flow at

MaturityBorrow $900 +900 -900(1+0.05)1

Buy gold for $900 -900 ST

Short gold futures at F0=960 0 960 - ST

TOTAL 0 960-900(1+0.05)1 = $15

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2. Gold: Another Arbitrage Opportunity? Suppose that:

The spot price of gold is US$900 The 1-year futures price of gold is US$890 The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?Action at time 0 Initial Cash

FlowCash Flow at

MaturitySell short gold for $900 +900 -ST

Lend $900 -900 +900(1+1.05)1

Long gold futures at F0=890 0 ST - 890

TOTAL 0 900(1+1.05)1-890 = $5542

The Forward/Futures Price of Gold If the spot price of gold is S and the futures price for a contract deliverable in T

years is F, thenF = S (1+r )T

where r is the 1-year (domestic currency) risk-free interest rate.The continuous version of cost of carry model F = SerT

where r is the 1-year continuously compounded risk-free interest rate.

Future price (relative cost of buying a gold with deferred delivery) = spotprice (cost of buying the gold in the market) and carrying it in inventory.

Cost of carrying gold = risk-free rate If this parity is violated, this can be arbitraged as previously shown. Arbitrage: strategy to exploit the mispricing that will produce a riskless

profit.In our examples, S=900, T=1, and r=0.05 so that

F = 900(1+0.05)1 = 945

Cost-of-carry relationship

$900 is spot cost, and $45 is thecost-of-carry

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3. Oil: An Arbitrage Opportunity?Suppose that:

- The spot price of oil is US$120- The quoted 1-year futures price of oil is US$135- The 1-year US$ interest rate is 5% per annum- The storage cost of oil is $2 per barrel

Is there an arbitrage opportunity?

Action at time 0 Initial Cash Flow

Cash Flow at Maturity

Borrow $120 +120 -120(1+0.05)1

Buy oil for $120 -120 ST

Cost of storing oil 0 -2Short oil futures at F0=135 0 135 - ST

TOTAL 0 135 - 120(1+0.05)1 - 2 = $744

4. Oil: Another Arbitrage Opportunity?Suppose that:

- The spot price of oil is US$120- The quoted 1-year futures price of oil is US$119- The 1-year US$ interest rate is 5% per annum- The storage cost of oil is $2 per barrel

Is there an arbitrage opportunity?



Sell short oil for $120 +120 -ST

Lend $120 -120 +120(1+0.05)1

Save cost of storing oil 0 +2Buy oil futures at F0=119 0 ST - 119

TOTAL 0 120(1+0.05)1+2 - 119= $9

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The Forward/Futures Price of Asset with Storage Cost

If the spot price of asset is S and the futures price for a contract deliverable in T years is F, then

F = S (1+r)T + swhere r is the 1-year (domestic currency) risk-free rate of interest,

and s is the dollar storage cost The continuous version of cost of carry model F = Se(r+s)T

where r and s is the 1-year continuously compounded risk-free interest rate and storage cost rate.

Cost of carrying asset = risk-free rate and storage cost If this parity is violated, this can be arbitraged as previously shown.

In our examples, S=120, T=1, r=0.05, and s=$2 so thatF = 120(1+0.05)1 +2 = 128


$120 is spot cost, and $8 isthe cost-of-carry 46

5. Stock Index: An Arbitrage Opportunity?Suppose that:

- The spot price of SET50 index is 450- The quoted 6-month futures price of SET50 is 465- The 1-year Thai Baht interest rate is 5% per annum- The dividends paid from constituent stocks in the SET50 are Baht 5

in the next 6 months Is there an arbitrage opportunity?



Borrow $450 +450 -450(1+0.05)1/2

Buy SET50 for $450 -450 ST

Receive dividends 0 +5

Short SET50 futures at F0=465 0 465 - ST

TOTAL 0 465 - 450(1+0.05) 1/2 + 5 = $8.9

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6. Stock Index: An Arbitrage Opportunity?Suppose that:

- The spot price of SET50 index is 450- The quoted 6-month futures price of SET50 is 452- The 1-year Thai Baht interest rate is 5% per annum- The dividends paid from constituent stocks in the SET50 are Baht 5 per

annum Is there an arbitrage opportunity?



Sell SET50 for $450 +450 -ST

Lend $450 -450 +450(1+0.05)1/2

Pay dividends 0 -5

Buy SET50 futures at F0=452 0 ST – 452

TOTAL 0 450(1+0.05) 1/2 - 5 – 452 = $4.148

The Forward/Futures Price of Asset with Dividend


F = S (1+r)T - Dwhere r is the 1-year (domestic currency) risk-free rate of interest,

and D is the dollar amount of dividend paid The continuous version of cost of carry model F = Se(r-d)T

where r and d is the 1-year continuously compounded risk-free interest rate and dividend yield.

Net Cost of carrying asset = risk-free rate minus dividend paid If this parity is violated, this can be arbitraged as previously shown.

In our examples, S=450, T=0.5, r=0.05, and D=$5 so thatF = 450(1+0.05)1/2 - 5 = 456.1


$450 is spot cost, and $6.1 isthe net cost-of-carry

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7. Currency: An Arbitrage Opportunity?Suppose that:

- The spot price of USD is 33 baht- The quoted 1-month futures price of USD is 33.8 baht- The 1-year Thai Baht interest rate is 5% per annum, and the 1-year US$

interest rate is 4% per annum

Is there an arbitrage opportunity?Action at time 0 Initial

Cash FlowCash Flow at Maturity

Borrow 33 baht +33 -33(1+0.05)1/12

Buy USD for 33 baht -33 ST

Receive “dividends” 0 +33(1+0.04)1/12 - 33

Short USD futures at F0=33.8 0 33.8 - ST

TOTAL 0 33.8 – [33(1+0.05) 1/12 -33(1+0.04)1/12 + 33] = .77

US risk-free rate of 4%

Terms in the bracket can beapproximated by 33(1+0.05-0.04)1/12 50

8. Currency: An Arbitrage Opportunity?Suppose that:

- The spot price of USD is 33 baht- The quoted 1-month futures price of USD is 32.8 baht- The 1-year Thai Baht interest rate is 5% per annum, and the 1-year US$

interest rate is 4% per annum

Is there an arbitrage opportunity?Action at time 0 Initial

Cash FlowCash Flow at Maturity

Sell USD for 33 baht +33 -ST

Lend 33 baht -33 +33(1+0.05)1/12

Pay “dividends” 0 - [33(1+0.04)1/12 – 33]

Long USD futures at F0=32.8 0 ST - 32.8

TOTAL 0 [33(1+0.05) 1/12 -33(1+0.04)1/12 + 33] – 32.8 = .23

US risk-free rate of 4%

Terms in the bracket can beapproximated by 33(1+0.05-0.04)1/12

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The Forward/Futures Price of Foreign Currency Assets


F = S (1 + r - ρ )T

The continuous version of cost of carry model F = Se(r-ρ)T

where r is the 1-year domestic currency risk-free interest rate, and ρ is the foreign currency risk-free interest rate

Net Cost of Carrying asset = domestic risk-free rate minus foreignrisk-free rate

If this parity is violated, this can be arbitraged as previously shown.In our examples, S=33, T=1/12, r=0.05, and d=0.04 so that

F = 33(1+0.05-0.04)1/12 = 33.03


33 is spot cost, and .03 is the net cost-of-carry 52

Futures Markets: Contango vs Backwardation In a Contango market, the futures price exceeds the spot price, that is,

f0(T) > S0. See Table 9.2.

When f0(T) < S0, convenience yield is c , an additional return from holding asset when in short supply/high demand or a non-pecuniary return (e.g., the utility from living in the house owned).

When the commodity has a convenience yield, the futures price may be less than the spot price plus the cost of carry. In that case, the market is said to be at less than full carry and in Backwardation or inverted (See Table 9.3).

Market can be both backwardation and contango --> Table 9.4.

The inability to sell short the asset and the reluctance on the part of holders of the commodity to sell it when its price is higher than it should be can also produce backwardation in commodity markets.

53 5454

www.tfex.co.th

as of 22 March 2013

5555

www.set.or.th, www.tfex.co.th, www.goldtraders.or.th as of 29 March 2013

lecture 4 - futures and forwards - markets, basic

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