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Futures and Forwards

By Gopal Bhatta
March 2009
2 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
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 delivered
Settled daily
Futures Contract
A futures contract is an agreement between two parties
to buy or sell an asset at a certain time in the future for
a certain price.
Unlike forward contracts,future contracts are normally
traded 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 know
each other, the exchange also provides a mechanism
that gives the two parties a guarantee that the contract
will be honored.
Background of Mechanics of Futures Markets
Future contracts are now traded actively all over the
The largest Future exchanges in US
Chicago Mercantile Exchange-
London International Financial Futures and Options
Tokyo International Financial Futures Exchange-

The Specification of a Futures Contract
While developing a new contract, the exchange
must specify in some detail:
The asset
The contract size (exactly how much of the asset will
be delivered under one contract)
Where delivery will be made
When delivery will be made

The Asset
When the asset is a commodity, there may be a quite
variation in the quality of what is available in a market
place. The New York Cotton Exchange has specified
the 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 1
nor more than 19 to 1, with factors of colors and flavor
each scoring 37 points or higher and 19 for defects, with
a minimum score 94.
The financial assets in futures contract are generally well
defined and unambiguous.
The Contract Size
The contract size specifies the amount of asset
that has to be delivered under one contract.
If contract size is too large, investors who wish to
take small speculative position will be unable to
use the exchange.
If contract size is too small, trading may be
expensive, as there is a cost associated with
each contract.
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)
9 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
If a futures contract is not closed out before maturity, it is
usually settled by delivering the assets underlying the
contract. 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
Delivery Arrangements
The where delivery will be made must be specified by
the exchange.
An example : CMEs random length lumber contract.
The delivery location is specified as:
On track and shall either be unitized in double door
boxcars or, at no additional cost to buyer, each unit
shall be individually paper-wrapped and loaded on
flatcars. par deliver of hem-fir in California, Idaho,
Montana, Nevada, Oregon, and Washington, and in the
province of British Columbia.
Delivery Months
A futures contract is referred to by its delivery
The exchange must specify the precise period
during 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 on
which trading can take place for a given contract.
12 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Some Terminology
Open interest: the total number of contracts
equal to number of long positions or number of
short positions
Settlement price: the price just before the final bell
each day
used for the daily settlement process
Volume of trading: the number of trades in 1 day
13 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
A margin is cash or marketable securities
deposited by an investor with his or her broker
The balance in the margin account is adjusted to
reflect daily settlement
Margins minimize the possibility of a loss
through a default on a contract
14 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Example of a Futures Trade
An investor takes a long position in 2
December 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 in
maintenance margin is US$1,500/contract (US$3,000 in
15 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
A Possible Outcome
Table 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
16 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
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 before
17 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Convergence of Futures to Spot (Figure
2.1, page 25)

Time Time
(a) (b)
Spot Price
Spot Price
18 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Regulation of Futures
Regulation is designed to protect the
public interest
Regulators try to prevent
questionable trading practices by
either individuals on the floor of the
exchange or outside groups
19 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Accounting & Tax
It is logical to recognize hedging profits (losses)
at the same time as the losses (profits) on the
item being hedged
It is logical to recognize profits and losses from
speculation on a mark to market basis
Roughly speaking, this is what the accounting
and tax treatment of futures in the U.S.and
many other countries attempts to achieve
Introduction to Forward Contract
A forward contract gives the owner the right and
obligation to buy a specified asset on a specified date at
a specified price.
The seller of the contract has the right and obligation to
sell the asset on the date for that specified price.
At delivery, ownership of good is transferred and
payment is made.
The agreement is made today to exchange cash for a
good or service at a later date.
In a spot transaction, one party pays for a good or
service, and immediately receives that good or service.
21 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Forward Contracts
A forward contract is an OTC agreement
to buy or sell an asset at a certain time in
the future for a certain price
There is no daily settlement (unless a
collateralization agreement requires it). At
the end of the life of the contract one party
buys the asset for the agreed price from
the other party

22 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Profit from a Long Forward or
Futures Position
Price of Underlying
at Maturity
23 Fundamentals of Futures and Options Markets, 6
Edition, Copyright John C. Hull 2007
Profit from a Short Forward or
Futures Position
Price of Underlying
at Maturity
Futures vs. Forwards
Futures are standardized, Forwards custom made
Futures are more liquid than forwards.
Counter party risk is higher in forwards than in futures.
Most futures contract are eventually offset where as
most forward contract terminate with delivery of the
specific good.
While profits or losses on forward contracts are realized
only on the delivery day, the change in the value of
futures contract results in a cash flow every day. Less
default risk with futures contract.

Forward Contracts vs Futures
Contracts (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, 6
Edition, Copyright John C. Hull 2007
Forwards:General Concepts
Two parties:
Buyer: agrees to buy something in future, Long position
Seller: Obligation to sell something in future, Short position
Delivery date
The terms of the contract are agreed upon today, and
delivery 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
Forwards:General Concepts (2)
Money rarely changes hands when a forward
contract is originated.
However, one or both of the parties may demand
good faith money to serve as collateral that
backs up the obligations stated in the contract.
Payment from the buyer of the forward contract
to the seller is generally made only upon the
delivery of the good.
Forwards:General Concepts (3)
Most business transactions are actually forward
A firm might order 10,000 widgets from another firm.
The price is agreed upon today. No cash flows occur
The widgets will be delivered one month hence.
Payment is not made until after the widgets have been
For all practical purposes, this is a forward contract.
Forwards:General Concepts (4)
The failure of a party to do what has been agreed to, as
stated in the contract, is known as default.
On the day that a forward contract is originated, both
parties face possible default risk: the future uncertainty
concerning the other parties ability and/or willingness to
fulfill the terms of the contract.
Penalties for failing to fulfill the terms of forward
contracts vary, however, in business default is serious
matter that will likely to lead to legal action.
Forwards:General Concepts (5)
Forward price is the specified price in forward contract
to be paid in future specified date. It differ from spot
price which is today's price for delivery.
A fair forward price will result in a forward contract that
has 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 supply
of forward contracts at that forward price.
The value of a forward contract at that fair forward price
is zero.

Forwards:General Concepts (6)
Forward contracts, like all derivatives, are zero sum
games. Whatever one party gains, the other party must
The profit and losses associated with forward contracts
are typically realized at delivery.
Before delivery, as forward prices for delivery on the
settlement date of the original contract fluctuate, each
party could experience unrealized gains and losses.
Forwards:General Concepts (7)
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 =
the spot price on the deliver date = S(T)
The actual profit or loss for the party that is long the forward
contract is then S(T) F(0,T) per unit of the good under
The actual profit or loss for the party that is short the forward
contract is the same amount, but the opposite sign: F(0,T) -
Many forward contracts are cash settled. No delivery takes
place on the settlement date.
Forwards:General Concepts (8)
It was stated that when a forward contract is originated,
it has no value.
At subsequent times, it will almost surely have positive
value for one party and negative value for the other
When a forward contract becomes an asset (has
positive value) for one party, that party will become
concerned about the default risk or performance or
credit risk of counter party.
At a point in time only one party, the one for which the
forward contract is an asset, will worry about current
default risk.

Convergence of Futures Price to Spot Price
As the delivery period for a futures contract is
approached, the futures price converges to the
spot price of the underlying asset
When the delivery period is reached, the futures
price equals or is very close to- the spot price.
If futures price is above or below the spot price,
there exist an arbitrage opportunity.
The Clearing House
Each futures exchange has an associated clearing
house that becomes the sellers buyer and the
buyers seller as soon as a trade is concluded.
When investors (long and short trader) reach in their
agreements though their brokers in exchange, the
clearing house will immediately step in and break the
transaction apart.
The clearing house is in potentially risky position if
nothing regarding the margin requirements are done.
Initial Margin
In order to buy and sell futures contract, an investor
must 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.make
security deposits that are intended to guarantee that will
in fact be able to fulfill their obligations.
the amount of this margin is roughly 5-15% of the total
purchase price
this deposit can be made in the form of either cash or
cash equivalents, or a bank line of credit, and it forms
the equity in the account on the first day.
Initial margin does not provide complete protection.
Marking to Market
The process of adjusting the equity in an investors
account in order to reflect the change in the settlement
price of the futures contract is known as Marking to
As a part of marking to market clearing house every day
replaces each existing futures contract with a new one
that has as the purchase price the settlement price as
reported in the financial press.
The equity in buyers or sellers account is initial margin
deposit plus the sum of all daily gains less losses on
open positions in futures.
As the amount of gains (or losses) changes every day,
the amount of equity changes every day.
Marking to Market (2)
An Example;
A July wheat contract future for 5000 bushels at $5 per
bushel 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
B account dropped to $750 and Ss equity has risen to
Maintenance Margin
The investor must keep the accounts equity equal to or
greater than a certain percentage of the amount
deposited as initial margin (roughly > or =65% of initial
If this requirement is not made, the investor will receive
a margin call from his or her broker.
The call is a request for an additional deposit of cash
known as variation margin to bring the equity up to the
initial margin level.
If the investor does not respond , then the broker will
close out the investors position by entering a reversing
trade in the in the investors account.

Closing Out positions
The vast majority of futures contracts do not lead to
delivery. The reason is that most traders choose to
close out their positions prior to the delivery period
specified in the contract.
Closing out a position means entering in to the opposite
type of trade from the original one.
Once the reversing trade has been made, the trader will
be able to withdraw money from his equity account.
Delivery is so unusual that traders sometime forget how
the delivery process works.