Chapter 22

Forward and Futures Contracts

Questions to be answered:
What are the differences in the way forward
and futures contracts are structured and
traded?
How are the margin accounts on a futures
contract adjusted for daily changes in market
conditions?
How can an investor use forward and futures
contracts to hedge an existing risk exposure?
Chapter 22
Forward and Futures Contracts
What is a hedge ratio and how should it be
calculated?
What economic functions do the forward and
futures markets serve?
How are forward and futures contracts valued
after origination?
What is the relationship between futures
contract prices and the current and expected
spot price for the underlying commodity or
security?
Chapter 22
Forward and Futures Contracts
How can an investor use forward and futures
contracts to speculate on a particular view
about changing market conditions?
How do agricultural futures contracts differ
from those based on financial instruments, such
as stock indexes, bonds, and currencies?
How can forward and futures contracts be
designed to hedge interest rate risk?
Chapter 22
Forward and Futures Contracts
How are implied forward rates and actual
forward rates related?
What is stock arbitrage and how is it related to
program trading?
How can forward and futures contracts be
designed to hedge foreign exchange rate risk?
What is interest rate parity and how would you
construct a covered hedge interest arbitrage
transaction?
An Overview of
Forward and Futures Trading
Forward contracts are negotiated directly
between two parties in the OTC markets.
Individually designed to meet specific needs
Subject to default risk
Futures contracts are bought through brokers
on an exchange
No direct interaction between the two parties
Exchange clearinghouse oversees delivery and
settles daily gains and losses
Customers post initial margin account
Hedging With Forwards and Futures
Create a position that will offset the price risk of
another holding
holding a short forward position against the long
position in the commodity is a short hedge
a long hedge supplements a short commodity holding
with a long forward position
Hedging With Forwards and Futures
Relationship between spot and forward price
movements
basis is spot price minus the forward price for a
contract maturing at date T:
B
tT
= S
t
- F
t,T
forward price converges to the spot price as the
contract expires
hedging exposure is correlation between future
changes in the spot and forward contract prices and
can be perfectly correlated with customized contracts
Optimal Hedge Ratio

In hedging, you can hedge your whole
portfolio or some portion of it.
The hedge ratio is the size of the futures
contract relative to the cash transaction.


S = ST - St = the change in the spot price over the life of the
contract
F = FT - Ft = the change in the futures price over the life of
the contract
S = the standard deviation of S
F = the standard deviation of F
= SF/(SF) = the correlation coefficient between S and
F, which is the covariance of S and F divided by the
standard deviations of S and F, and
h = the hedge ratio
If the hedger owns the products and sells the
future, his portfolio value is (S - hF). The change
in value of the portfolio is
S - hF.
Alternatively, if the hedger buys the future and is
short the product, his portfolio value is hF - S.
The change in value of the portfolio is
hF - S.


The variance (2) for the above two
portfolios is

To find the optimal hedge ratio, which
minimizes risk or variance, minimize the
above expression with respect to h.

Hedging With Forwards and Futures
Calculating the Optimal Hedge Ratio
net profit from the position
( ) ( )( ) ( ) ( )( ) N F S N F F S S
T T t t t
A A = = H
, 0 , 0
( ) ( )
F S, F S T t
N N
A A A A
+ = COV 2
2 2 2 2
,
o o o
p N
F
S
F
|
|
.
|

\
|
= =
A
A
A
A A
-
o
o
o
2
F S,
COV
Now if S and F are for the same products it is likely that
S and F are close to the same value and is close to 1.
Then the optimal hedge ratio is near 1.
Where this becomes more interesting is where you are
hedging one product with a different products future
contract.
For example, you might use Henry Hub gas to hedge for
gas at Waha or some other hub. Then S and F may not
be close to the same and may not be close to 1. The
closer is to one, and the larger is the variance of the
product you are hedging, the more you hedge. The larger is
the variance of the product used to hedge the lower the
hedge ratio. It is even possible that h would be greater than
1

Example
A company knows that it will buy 1 million
gallons of jet fuel in 3 months. The STD DEV of
the change in the price per gallon of jet fuel over
3 months is 0.032. The company to chooses to
hedge by buying futures contract of heating oil.
The STD dev of the change in the futures price
over a 3 month period is 0.040, correlation
between spot and futures price is 0.8. What is the
optimal hedge ratio ?

0.8*0.032/0.04= 0.64.
One heating oil futures contract is on 42000
gallons. The company should therefore buy
=0.64*1000000/42000= 15 contracts

Forward and Futures Contracts:
Basic Valuation Concepts
Forward and futures contracts are not
securities but, rather, trade agreements that
enable both buyers and sellers of an
underlying commodity or security to lock in
the eventual price of their transaction
The Relationship Between Spot and
Forward Prices
If you buy a commodity now for cash and store
it until you deliver it, the price you want under a
forward contract would have to cover:
the cost of buying it now
the cost of storing it until the contract matures
the cost of financing the initial purchase
These are the cost of carry necessary to move the
asset to the future delivery date
( )
T T T T T
D i PC S SC S F
, 0 , 0 , 0 0 , 0 0 , 0
+ + = + =
Currency Forwards and Futures
Currency quotations
Direct (American) quote in U.S. dollars
Indirect (European) quote in non U.S. currency
Reciprocals of each other
Interest rate parity and covered interest arbitrage
( )
( )
|
|
|
|
.
|

\
|
|
.
|

\
|
+
|
.
|

\
|
+
=
365
Rate Interest U.S. 1
365
Rate Interest Foreign 1
Spot Forward
T
T
Pricing Futures
Backwardation and Contango
Contango is the situation when
FP>SP

Backwardation is the situation when
SP>FP

The Relationship Between Spot and
Forward Prices
Contango - high storage costs and no
dividends
Premium for owning the commodity
Backwardated market - future is less
than spot
Pricing futures

The cost of carry model
We use fair value calculation of futures to decide the no-
arbitrage limits on the price of a futures
contract. This is the basis for the cost-of-carry model
where the price of the contract is defined as:
F = S+ C
where:
F Futures price
S Spot price
C Holding costs or carry costs

Pricing futures contd..
This can also be expressed as:
This can also be expressed as:
F = S (1+R) ^ T
R= cost of financing
T = time to expiry
If F < S(1+R) ^t or F > S (1+R) ^ T, arbitrage
opportunities will exists. So therefore whenever
the futures price moves away from the fair value,
there would be chances for arbitrage


Pricing futures contd..
We know what the spot and futures prices are, but
what are the components of holding cost?
The components of holding cost vary with
contracts on different assets. At times the holding
cost may even be negative.
In the case of commodity futures, the holding cost
is the cost of financing plus cost of storage and
insurance purchased etc. In the case of equity
futures, the holding cost is the cost of financing
minus the dividends returns

Pricing futures contd..
Pricing of options and other complex derivative
securities requires the use of continuously
compounded interest rates. Most books on
derivatives use continuous compounding for
pricing futures too. However, we have used
discrete compounding as it is more intuitive and
simpler to work with. Had we to use the concept
of continuous compounding, the above equation
would have been expressed as:
F=S ^ ET
Example
The spot price of silver is Rs.7000/kg. If the
cost of financing is 15% annually, what
should be the futures price of 100 gms of
silver one month down the line (T=30 days)
F= 700*(1+0.15)^(30/365)

Pricing equity index futures

A futures contract on the stock market index
gives its owner the right and obligation to
buy or sell the portfolio of stocks
characterized by the index. Stock index
futures are cash settled; there is no delivery
of the underlying stocks

The main differences between commodity and
equity index futures are that:

There are no costs of storage involved in holding
equity.
Equity comes with a dividend stream, which is a
negative cost if you are long the stock and a
positive cost if you are short the stock.
Therefore, Cost of carry = Financing cost - Dividends.
Thus, a crucial aspect of dealing with equity futures as
opposed to commodity futures is an accurate forecasting
of dividends. The better the forecast of dividend offered
by a security, the better is the estimate of the futures
price.



Pricing index futures given expected dividend
amount

The pricing of index futures is also based on
the cost-of-carry model, where the carrying
cost is the cost of financing the purchase of
the portfolio underlying the index, minus the
present value of dividends obtained from
the stocks in the index portfolio.

Example

Nifty futures trade on NSE as one,two and three-
month contracts. Money can be borrowed at a rate
of 15% per annum. What will be the price of a
new two-month futures contract on Nifty?
Let us assume that M&M will be declaring a dividend
of Rs. 10 per share after 15 days of purchasing the
contract.
Current value of Nifty is 1200 and Nifty trades with a
multiplier of 200.
Since Nifty is traded in multiples of 200, value of the
contract is 200*1200 = Rs.240,000.


Example contd..
If M & M has a weight of 7% in Nifty, its value in Nifty
is Rs.16,800 i.e.(240,000 * 0.07).
If the market price of M & M is Rs.140, then a traded
unit of Nifty involves 120 shares of M & M
.(16,800/140).
To calculate the futures price, we need to reduce the
cost-of-carry to the extent of dividend received. The
amount of dividend received is Rs.1200 i.e.(120 * 10).
The dividend is received 15 days later and hence
compounded only for the remainder of 45 days. To
calculate the futures price we need to compute the
amount of dividend received per unit of Nifty. Hence we
divide the compounded dividend figure by 200.


F=1200*(1.15)^60/360) - 1200*(1.15)^45/360)/200)= 1221.80
Cost of Carry Expected dividend
-

Pricing index futures given expected dividend
yield

If the dividend flow throughout the year is
generally uniform, i.e. if there are few
historical cases of clustering of dividends in
any particular month, it is useful to
calculate the annual dividend yield
F = S (1+R-Q)^T
R= cost of financing, Q = expected dividend.
T= holding period.

Example

A two-month futures contract trades on the
NSE. The cost of financing is 15% and the
dividend yield on Nifty is 2% annualized.
The spot value of Nifty 1200. What is the
fair value of the futures contract? Fair value
F = 1200 (1+0.15-0.02)^60/365=1224
The cost-of-carry model explicitly defines
the relationship between the futures price
and the related spot price. As we know, the
difference between the spot price and the
futures price is called the basis.

differentiate between margin in the securities markets
and margin in the futures markets;

In securities markets, margin on a stock
purchase is a % of the market value of the
assets
In futures market margins are performance
guarantee
describe how a futures trade takes place ?

In contrast to a forward contract in which a bank
or brokerage is usually the counter party to the
contract, there is a buyer and a seller on each side
of the futures contract. The futures exchange will
select the contract.
Each time there is trade, the delivery price for that
contract is the equilibrium price at that point in
time, which depends on supply
describe how a futures position may be closed
out (i.e., offset) prior to expiration

You may make a reverse or offsetting trade in the
futures market.
The contract price can differ between2 contracts.
If u r initially long on contract at $370 per ounce
of gold and subsequently sell an identical gold
contract when the price is $ 350 per ounce, $ 20
times the number of ounce of gold specified in the
contract will be deducted from the margin deposit
define initial margin, maintenance margin,
variation margin, and settlement price;

Initial Margin: is the money that must be deposited in a
futures account before any trading takes place. Initial
margin per contract is relatively low and equals about
one days maximum price fluctuation on the total value
of the underlying assets
Maintenance margin : is the amount of margin that
must be maintained in the futures account, if the
margin balance falls below the maintenance margin due
to change in the contract price of the underlying asset
additional funds must be deposited to bring the
margin balance back up to the initial margin
requirement. This is in contrast to equity
margins,which requires only to bring the margin %
upto to maintenance margin, not back to the initial
margin level

MARGIN
Initial Margin:The amount that must be deposited in the
margin account at the time a futures contract is first entered
into is known as initial margin.
Maintenance Margin:This is somewhat lower than initial
margin. This is set to ensure that the balance in the margin
account never becomes negative.
Marking-to-Market:In the futures market, at the end of
each trading day , the margin account is adjusted to reflect the
investors gain/loss depending upon the future closing price.
This is called marking-to-market.
Margin: Margin can be paid in terms of cash , bank
guarantee or other acceptable collateral.
MINIMUM MARGIN
Index Future=5%
Stock Future=7.5%
Short Index Option =3%

No of Units =100 XYZ Initial Margin= Rs.6000
Starting Date =2nd September Maintenance Margin=Rs.4500
Expiry Date= 21th September Current Future Price =Rs.900
Trading Day Future Daily Cumulative Margin Margin
September Price(Rs)Gain/(Loss) Gain/(Loss) Account Call
Balance
2 600.00 6000.00
598.20 -180.00 -180.00 5820.00
3 593.60 -460.00 -640.00 5360.00
4 594.00 40.00 -600.00 5400.00
5 589.50 -450.00 -1050.00 4950.00
6 584.80 -470.00 -1520.00 4480.00 1520
7 582.20 -260.00 -1780.00 5740.00
8 583.70 150.00 -1630.00 5890.00
9 577.30 -640.00 -2270.00 5250.00
10 577.10 -20.00 -2290.00 5230.00
11 572.40 -470.00 -2760.00 4760.00
12 570.10 -230.00 -2990.00 4530.00
13 568.50 -160.00 -3150.00 4370.00 1630
14 569.80 130.00 -3020.00 6130.00
15 573.80 400.00 -2620.00 6530.00
16 573.60 -20.00 -2640.00 6510.00
17 577.30 370.00 -2270.00 6880.00
18 576.80 -50.00 -2320.00 6830.00
19 578.80 200.00 -2120.00 7030.00
20 578.00 -80.00 -2200.00 6950.00
21 584.20 620.00 -1580.00 7570.00
Marking to Market for the XYZ Futures Contract
Mark to Market
The daily mark-to-market settlement price is the closing price of
the respective product.
It is computed on the basis of the last half-an hour weighted
average price of such contract in the F&O segment.
In case the contract is not traded during the last half-hour, the
daily settlement price shall be the theoretical price computed for
the contract.
Clearing Member are responsible to collect and settle the daily
mark to market profits/loses incurred by the Trading Member and
their clients clearing and settling through them. The pay-in and
pay-out of the mark-to-market settlement is on T+1.
define initial margin, maintenance margin,
variation margin, and settlement price
Variation margin: is the funds that must be
deposited into an account to bring it back to
the initial margin amount. If account margin
exceeds the initial margin requirement,
funds can be withdrawn or can be used as
initial margin for other trades,
Settlement price is the closing price

describe the process of
marking to market;

contract 5000
Nos of contract 5
contract price 2
Initial Margin 150 750
Maintaince margin 100 500
required dep price/bushel daily change gain-loss balance
0 750 2 0 0 750
1 0 1.98 -0.02 -500 250
2 500 1.99 0.01 250 1000
3 0 1.98 -0.01 -250 750
Compute margin balance, after -2%,+1%
and - 1% on day 1, 2 and 3 respectively