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Future Contracts

A contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a pre-determined price in the future. Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.

Characteristics of Futures:
Future contracts specify the quality and quantity of goods that can be delivered, the delivery time, and the manner of delivery. The exchange also sets the minimum price fluctuation (which is called the tick size). For example, the basic price movement, or tick, for a 5000 bushel grain contract is a quarter of a point (1 point = $0.01) per bushel. Contracts also have a daily price limit, which sets the maximum price movement allowed in a single day. For example, rice cannot move more than $0.2 from its close the preceding day. Price limit expands during period of high volatility. Uniformity in transaction promotes market liquidity. Purchaser of future contract is said to have gone long while the seller of contact is said to have gone short. The long has contracted to buy the asset at the contract price at contract expiration, and the short has an obligation to sell at that price. Futures are used by speculators to gain exposure to changes in price of the asset underlying a future contract. A hedger, in contrast, will use futures to reduce price changes in the asset. An example is a farmer who sells rice futures to reduce uncertainty about the price of rice in future. There is a clearinghouse whose responsibility is to make ensure that all traders in the future market will honor their obligations. Clearinghouse does this by splitting each trade once it is made and acting as opposite side of each position Clearinghouse acts as seller to the buyer and as buyer to the seller. To safeguard the clearinghouse, the exchange requires both sides of the trade to post margin and settle their accounts on a daily basis. Thus, the margin in the futures markets is a performance guarantee. Futures vs Forwards Futures contracts are very much like the forward contracts

the value of the long position increases. The value is set back to zero by the mark to market at the end of the mark-to-marker period. The government having legal jurisdiction regulates futures markets. Valuing Futures Futures contracts have no value at contract initiation. Forward contracts are not marked to market.   Deliverable contracts obligate the long to buy and the short to sell a certain quantity of an asset for a certain price on a specified future date. The value of a futures contract strays from zero only during the trading periods between the times at which the account is marked to market: Value of futures contract = current futures price -previous mark-to-market price If the futures price increases. Forward contracts are usually not regulated. Since futures accounts are marked to market daily. Futures contracts do not accumulate: value changes over the term of the contract. Forwards are customized contracts satisfying the needs of the parties involved. Cash settlement contracts are settled by paying the contract value in cash on the expiration date. the value after the margin deposit has been adjusted for the day's gains and losses in contract value is always zero. Forwards are private contracts and do not trade on organized exchanges. The futures price at any point in time is the price that makes the value of a new contract equal to zero. Futures contracts are highly standardized. In an ideal world future price must be e: FP=S0*(1+Rf)T where: FP = futures price . a specialized entity called a clearinghouse is the counterparty to all futures contracts. Both forwards and futures are priced to have zero value at the time the investor enters into the contract. Futures contracts trade on organized exchanges. There are important differences. including:       Futures are marked to market at the end of every trading day. Forwards are contracts with the originating counterparty.

 Lend short sale proceeds at market interest rates. If the futures contract is overpriced.S0 = spot price at inception of the contract (t = 0) Rf = annual risk-free rate T = futures contract term in years lf the correlation between the underlying asset value and interest rates is . positive Investor will Neutral negativw Prefer to go long in a futures contract. At contract expiration:     Deliver the asset and receive the futures contract price. and selling the asset at the futures price when the contract expires. and the forward price will be greater than the price of an otherwise comparable futures contract FUTURES ARBITRAGE A cash-and-carry arbitrage consists of buying the asset. this 5-step transaction will generate a riskless profit. the opposite of each step should be executed to earn a riskless profit. At the initiation of the contract:    Borrow money for the term of the contract at market interest rates. The futures contract is overpriced if the actual market price is greater than the no arbitrage price. Buy the underlying asset at the spot price. . This is reverse cash and carry arbitrage.. If the futures price is too low (which presents a profitable arbitrage opportunity). Repay the loan plus interest. Sell (go short) a futures contract at the current futures price. The steps in a cash-and carry arbitrage are as follows.. storing/holding the asset. and the futures price will be greater than the price of an otherwise comparable forward contract Have no preference Prefer to go long in a forward contract. The steps in reverse cash and carry arbitrage are as follows: At the initiation of the contract:  Sell asset short.

 . T-bond futures are quoted as a percent and fractions of 1% {measured in 1/32nds) of face value. however. Backwardation might occur if there are benefits to holding the asset that offset the opportunity cost of holding the asset (the risk-free rate) and additional net holding costs. it is called normal contango. The long pays the futures price at expiration multiplied by the conversion factor. the futures price will be FP = S0(1 + Rf)T + FV (NC). This is called a delivery option and is valuable to the short. and the minimum price change is one "tick. Each bond is given a conversion factor that is used to adjust the long's payment at delivery so the more valuable bonds receive a larger payment. either monetary or non monetary. Buy (go long} futures contract at market price.01 %. If there are no benefits to holding the asset (e.000. For this to occur there must be a significant benefit to holding the asset.  Take delivery of the asset for the futures price and cover the short sale commitment. At contract expiration:  Collect loan proceeds." which is a price change of 0. coupons1 or convenience yield). Contango refers to a situation where the futures price is above the spot price. A futures contract is viewed as a transfer of risk from an asset holder to the buyer of the contract and it is expected the futures price to be lower than the expected price in the future to compensate the future buyer for accepting asset price risk. dividends. The short in a T-bond futures contract has the option to deliver any of several bonds. These contracts settle in cash. These factors are multipliers for the futures price at settlement.0001 = 0. Backwardation and Contango Backwardation refers to a situation where the futures price is below the spot price. which is an add-on yield.g. or $25 per $1 million contract. The contract is deliverable with a face value of $100. By convention.. This situation is called normal backwardation. and contango will occur because the futures price will be greater than the spot price. Types of Futures  Eurodollar futures are based on 90-day LIBOR. the price quotes are calculated as (1 00 .annualized LIBOR in percent). Treasury bond {T-bond) futures are traded for T-bonds with a maturity of 15 years or more. which will satisfy the delivery terms of the contract. If the futures price is greater than the expected spot price.

Currency Futures The price of a currency future is done similar to how forwards are done.  Stock index futures are based on the level of an equity index. Contracts are set in units of the foreign currency. just as with the T-bill contract. and the price is stated in U. A smaller contract on the same index has a multiplier of 50. we have an arbitrage. dollars per unit of foreign currency. it is still a very useful. the rate you would earn on the face amount of a deposit. currency contracts trade on the euro. Mexican peso. the value of each contract is $250. An add-on yield account for 167 days that pays $1 at maturity can be valued at expiration (77 days later) using 90-day LIBOR 77 days from now (L90t=77) as: 1/(1+L90t=77) Prior to contract expiration. The most popular stock index future is the S&P 500 Index Future that trades in Chicago. Each index point in the futures price represents a gain or loss of $250 per contract. Every basis point (0. the bill will be a 90-day bill and its value should be equal to that of the (identical) bill covered by the contract. The value of a contract is 250 times the level of the index stated in the contract. the arbitrage strategy that creates the pricing bounds is straightforward.01 %) move in (annualized) 90-day LIBOR represents a $25 gain or loss on the contract. however. The currency futures market is smaller in volume than the forward market described in the previous topic review. While no riskless arbitrage relation exists for the Eurodollar futures contract. RFC and Roc are the riskfree returns in the two different currencies. hedging instrument for exposure to LIBOR. With an index level of 1000. Eurodollar Futures With T-bills.000. and yen. among others. is actually an add-on yield. The asset value is not perfectly hedged by the contract value as it is with the T-hill contract. In the United States. In 77 days. Settlement is in cash and is based on a multiplier of 250.S. Eurodollar futures do not allow such an arbitrage. S0 is the spot exchange rate. it will be worth the present value of the expectation of this value. This is important because the value of the deposit will not change $25 for every one basis point change in expected 90-day LIBOR in 77 days as does the value of the futures contract. If we sell a 77 -day future on a 90-day bill. and widely used. FT (currency futures contract) = S0 * (I+RDC)T/(I+RFC)T . and Fy is the price of a futures contract of T years duration. with both the spot and futures price quoted in units of domestic currency per one unit of foreign currency. The Eurodollar futures are priced as a discount yield and LIBOR is subtracted from 100 to get the quote. and buy a 167 -day bill. LIBOR.

The future account is marked-to-market based on the settlement price on the last day of trading.  . and a long can terminate the contract by accepting the delivery and paying the contract price to the short. Contract can be terminated by getting into a new contract that offsets the previous contract.where: DC = domestic currency FC = foreign currency The continuous time version with continuously compounded interest rates is: S0 * e(Rdc-Rfc )*T Termination of Contract There are 4 ways to terminate the contract:    A short can terminate the contract by delivering the goods. therefore the new contract is to be made with opposite settings with the contract. delivery is not an option. In a cash settlement contract. In this case clearinghouse needs to be informed about such trade. A position may also be settled through an exchange of physicals. In futures clearing house takes the opposite side.