Forwards and Futures

Definition
• Gives buyer of contract the right and obligation
to buy specified asset at a predetermined date
at a price set when contract signed.

• Contract contractually binding on both buyer

and seller (writer) of contract.
• With forwards and futures , no payment when
contract is signed, although needs to provide
deposit (=margin).

• => Can take large `position' in market with

limited initial investment.
 
• => Forwards and futures are leveraged
instruments.
Example (uses commodities for simplicity, even though this
course focuses on financial derivatives)

• Say current gold price = $1300 / ounce.

• Believe gold prices will rise, but not reflected in
market prices.
• Consider a Forward contract to buy gold @
$1300 per ounce in 6 month's time. Margin =
$100
• => Financial leverage = 1300 / 100 = 13
• Assume gold price in 6 months up 5% to $1365 =>
gold spot price gain = $65.
• If bought physical gold your gain = 5%
• If bought forward contract, gain
= $65 / $100 = 65%
• Similarly, experience large percentage losses if
gold prices decrease.
• So leverage implies magnification of potential
profits or losses.
Forward Contract
• Private and tailored agreement between two
parties.
• No payment is made when contract is signed,
although often you have to deposit a margin
(security or good-faith deposit).
• Margin set initially and usually not revised.
– =>large initial margins, to cover risk over life
of contract.
• As it is highly tailored to two parties’ needs,
Forward contract usually cannot be resold (no
secondary market).
– Have to wait till delivery to realise profit/loss
on contract.
 
• Profit (loss) on delivery date = difference
between market value of asset on delivery date
(spot price) and contracted agreed upon price
(forward rate/price).
Futures Contracts
• Standardised (not tailored) agreements traded
on organised derivative exchanges/markets.
• Contract standardises (specifies) all details
(underlying asset quality, quantity, future
delivery time, date, price and method).
• Clearing corporation/house splits initial
agreement between buyer and seller…
• (Buyer and seller initially meet through trading
platforms and agree or match a price and
quantity through submission of orders and the
application of the order matching mechanism of
the exchange)
• =>Buyer and seller end up having claims on
clearing house and not directly on each other.
• => eliminates counterparty risk.
• => allows for active trading (liquid market).
Margining System
• In order to protect itself, clearing house
requires margin from both parties.
Two types of margin required:

• Initial margin when contract signed. Amount

depends on volatility of value of futures contract.
(Typically 1‑10%).

• Maintenance margin = minimum level below

which margin deposit not allowed to fall once
daily losses/gains on the contract value are
taken into account. Maintenance margin usually
70‑80% of initial margin.
Marking-to-Market Procedure
• Futures prices fluctuate continuously
• => all contract positions are marked-to-market
at end of every day.
• If you gain on the position, gain added to margin
account. If exceeds required margin, customer
may withdraw cash.
• Conversely, if position makes a loss, loss is
added to the account.
• Once customer's account falls below
maintenance margin level, customer receives
margin call.
• Must provide additional margin (back to initial
margin level) immediately, otherwise futures
contract "closed" (sold) by broker.
• Additional top up is called ‘variation margin’.
• Daily marking to market implies that all profits
and losses are realised on a daily basis .
Example (uses gold as a simple example, but this courses
focuses on financial derivatives)

• On 1.January buy 6 month gold futures contract

@ $1300/ounce. Provide $100 margin.
• Margin account = $100.
• Next day 2. Jan. gold to be delivered in 5 months
and 29 days costs $1350.
• You have contract to buy @ $1300, gain $50,
added to margin account at end of day.
• Margin account = $100 + $50 = $150.
• The day after 3.Jan. gold to be delivered in 5
months and 28 days costs $1250.
• Change from price on 2.Jan. = $1350-$1250 =
$100
• Loss of $100 will be deducted from margin
account at the end of the day.
• Margin account = $150 - $100 = $50.
• Thus, adjustment to margin account occurs daily.
• If margin account exceeds the minimum required,
may withdraw the difference.
• If margin account falls below maintenance
margin level, must top up the account
immediately, otherwise position will be closed.
• Forward contracts are not marked-to-market.
Major difference between futures and forwards
• Very few financial futures contracts involve
actual delivery at maturity.
• (Contract closed by taking offsetting positions. E.
g., if written contract, repurchase futures
contract).
• Less than 3% of futures contracts end in actual
delivery of asset involved.
Basis
• Difference between futures and spot prices =
basis.
• Can be positive or negative.
• Basis converges to zero at maturity of contract.
• It incorporates all the expected changes in the
variables that may affect the price of the
underlying asset from now (spot) to the delivery
date (future).
Example of Basis

• Futures contract to buy 1 ounce of gold in one

year's time @ $1300 is currently trading at $20.
Current spot price of gold = $1315.

• Basis = Total price of asset if using futures

contract - current spot price = ($20 + $1300) -
$1315 = $5.
• Assume at end of contract spot price of gold =
$1327
• Delivery price (specified futures price) = $1300
• MV of contract must be $27
• => No basis at end of contract. Basis converges to
zero
• Basis due to timing differences.

• Futures valuation models determine theoretical

value of basis.
 
• Theoretical value of basis constrained by
existence of profitable riskless arbitrage
between futures and spot markets.
• Taxes and transaction costs can hinder arbitrage,
and make futures prices deviate from their
equilibrium values.
• Futures contract prices on commodities
determined by storage costs, insurance,
shrinkage, financing of spot purchase,
convenience yields, etc., otherwise arbitrage is
possible.
• For financial futures, current futures price must
be risk-adjusted expected spot price, otherwise
arbitrage is possible.
Commodity Futures
• Available for energy, metals, agricultural
products, …, etc. (e.g. oil, natural gas, heating oil,
gold, silver, copper, palladium, platinum, cotton,
soybeans, corn, coffee, cocoa, sugar, peas,
peanuts,…, etc.)
• Pricing of commodities futures contracts
difficult as spot markets may not exist or too
thin for arbitrage.
Financial Futures
• Interest rates, stock indices, forex, individual
stocks…etc.
• This course focuses on interest rate, stock index
and currency futures.
Interest Rate Futures
• Forward rate of interest: Fix interest rate today
for investment/loan in the future.
• Futures contract: Payoff depends on changes in
interest rates.
• Principal (or face value of contract) is a ‘notional
amount’ that is never exchanged. Only interest
on the notional principal is exchanged.
• Do not invest the full "notional" amount of
contract, but put up margin (security).

• Buyer of interest rate future gains if interest

rates fall, and loses if interest rates rise during
period of contract. Vice versa for writer.

• Interest rate futures most actively traded

futures contracts.
• Contracts on short-term interest futures quoted
at a discount from 100. At delivery, contract
price equals 100 minus interest rate of
underlying instrument.
Example

• Contract size of Sterling futures = £500,000.

• In January, three month June futures quoted @
94.89%
• => In January, the three-month forward interest
rate (annualised) due to start in June = 5.11% (i.
e., 100% - 94.89%).
• If, at delivery in June, three-month interest rate
less than 5.11%, buyer of futures contract at
94.89% will profit.

• Conversely, if three-month interest rate risen

above 5.11%, buyer of contract will lose.
• Interest rate for three-month instruments
quoted on annual basis.
• => Interest paid on three-month instrument =
annual yield divided by four.

 
• Profit/(loss) on £500,000 futures contract on 3-
month interest rates future
=futures price variation/4 * contract size
• Assume that at delivery (June), three-month
interest rate is 6% (rather than 5.11%, as
forecasted).

• With interest rate at 6%, the futures price will be

(100% - 6%) = 94.00%
• Loss to buyer of one £500,000 contract:
= [(94% - 94.89%) / 4] * £500,000
= (£1,112.50)
• If interest rates had fallen to 5%, futures price at
delivery would have been 95.00% (100% - 5%).
Profit:
= [(95% - 94.89%) / 4] *£500,000
= £137.50
• Short-term interest rate futures create deposit
commencing several months hence.
• Valuation complicated as futures written on
security that does not yet exist (=> no spot). 
• Valuation of such a contract usually obtained by
observing two interest rates currently quoted in
the market.
Long-term contracts
• Quotation for long-term interest rate futures
different.
• Contract usually defined in reference to a
theoretical bond = notional bond.
• E.g., use 8% coupon bond with 20 year maturity.
Calculate change in value of this hypothetical
bond from change in interest rates. If interest
rates up, buyer of long-term futures contract
loses.
• (Not expected to know details of long-term
interest futures)
Currency Futures

• Fix today exchange rate for future transaction.

• Currency futures exchange rate cannot differ
from spot exchange rate adjusted by interest
rate differential in the two currencies,
otherwise arbitrage.
• => Interest Rate Parity of foreign exchange
rates.
Example
• Current $/£ spot exch. Rate = 1.95
• One year $ interest rate = 9%
• One year £ interest rate = 5%
• Invest for one year:
– $1.95 * 1.09 = $2.1255
– 1£ * 1.05 = £1.05
•  One year forward exchange rate must be:
– $2.1255/£1.05 = 2.0249 $/£
• Futures contract have value.

• If specified exchange rate e.g., 2.0 $/£, contract

to buy £ in exchange for $ becomes valuable.
Stock Index Futures
• Futures contract on the level of a stock index, e.g.,
FTSE100, S&P500.
• Contract size is a monetary multiple of index level.
• E.g., size of FTSE100 contract traded on LIFFE = £10
times the FTSE100 index.
• The underlying asset (the index) does not exist
physically as a financial asset.
– => All final settlements in cash
Example
• 1 January buy 3-month futures contract on
FTSE 100 @ 6800 points.
• Assume that at 1 April FTSE 100 @ 7000
• Total gain: (7000-6800) * £10 = £2,000.
• Had index on 1 April been below 6800, buyer of
futures contract would have lost, and seller
gained
• Basis for stock index futures determined by
arbitrage. Basis should equal opportunity cost
of directly buying stocks in cash market.

• Larger cash outlay to buy shares than index

future (leveraged instrument). Cost of financing
stocks linked to short-term interest rate.
• Contract delivers the underlying index but
without the dividends.
• Thus, underlying the contract is the index
weighted average of stock prices (but without
adjustment for dividend payments).
• Forward rate on index should be
– = Spot index level*(1 + intr.-rate - dividend
yield)
• This is called the ‘cost of carry’.
Example
• Current level of index = 6800 points.
• Annual interest rate = 10%
• Expected annual dividend yield = 5%
 
• One year forward rate on index:
= 6800 * (1 + 0.1 - 0.05) = 7140
• With index futures, can invest easily in a broad,
diversified share portfolio.
• By writing (shorting) index futures, one can
hedge against general market movements. If
market drops, the index futures become valuable.
• Hedging using futures, therefore, means always
taking the opposite position to that in underlying
asset. (If want to hedge a portfolio you hold, then
need to sell futures).
END