Professional Documents
Culture Documents
1
Introduction
► Futures and Forward are contracts between
two parties that require specific action at a
later date which is most often the delivery
of the underlying asset. These contracts are
also known as contracts for deferred
delivery.
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Forward Contract
►A forward contract is a simple derivative that
involves an agreement to buy/sell an asset on a
certain future date at an agreed price.
► This is a contract between two parties, one of
which takes a long position, agreeing to buy the
underlying asset on a specified future date for a
certain specified price. The other party takes the
short position, agreeing to sell the asset at the
same date for the same price.
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Forward Contract
Salient features of a forward contract
They are bilateral contracts and hence exposed to counter-
party risk.
Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and asset type and
quality.
The contract price is not generally available in public
domain.
On expiration date, the contract has to be settled by the
delivery of the asset.
If the party wishes to reverse the contract, it has to
compulsorily go to the same counter-party which often
results in high prices being charged.
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Forward Contract
► When one orders a car which is not in stock,
from a dealer, one is in fact buying a
forward contract for the delivery of a car.
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Forward Contract
► The mutually agreed price in a forward contract is known as
the delivery price.
► The delivery price is chosen in such a way that the value of
the forward contract to both the parties is zero, which means
that it does not cost anything to take either a long or short
position.
► On maturity, the contract is settled so that the holder of the
short position delivers the underlying asset to the holder of
long position, who in turn pays a cash amount equal to the
delivery price.
► It may be noted that while the delivery price contracted
remains the same, the value of contract to the parties
involved is determined by the market price of the underlying
asset. Changes in market price bring about changes in the
contract value.
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Forward Contract
► Example: Suppose gold is currently selling at Rs. 11500/- per
10 gms. Based on the perception of the movement of gold
prices, A & B enter into a contract where A takes a short
position and thereby agrees to deliver 10 gms of gold to B on
31st Dec of the year at a price of Rs. 12000/- and B agrees to
take the delivery and pay the agreed price. Now, if there is a
spurt in market price of gold, it would investor B happy since
an increase in spot price would also cause the price expected
in future to increase. If the price increase does stay at the
date of the maturity of contract, the buyer would stand to
gain and the seller to lose from it.
► Thus, although the delivery price does not change, the value
of the contract to the long increases and to the short
decreases with the increase in the market value of the
underlying asset & vice-versa.
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Forward Contract- Forward Price
► The forward price of a contract is the delivery price which
would render a zero value to the contract. ‘Zero value’
implies that no party is required to pay any amount to the
other when the contract is entered into.
► Upon initiation of the contract the delivery price is so
chosen that the value of the contract is nil i.e. delivery
price and forward price are identical.
► With the passage of time, the forward price would change
& the delivery price would remain unchanged.
► Generally, the forward price at any given time varies with
the maturity of the contract. The forward price of a
contract to buy/sell in one month would be typically
different from that of a contract with a time of three
months or six months maturity.
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Forward Contract- Forward Price
► The pay off from a long position in a forward contract on
one unit of asset is equal to the excess of the spot price of
the asset on the maturity of the contract over the delivery
price.
► Symbolically, if ST be the spot price of the asset at the date
of the maturity and E be the delivery price agreed upon in
the contract then
ST>E ST=E ST<E
Pay off for long position ST-E Gain Break-even Loss
Pay off for short position E-ST Loss Break-even Gain
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Forward Contract- Forward Price
Patterns of Future/ Forward Prices
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Limitations of the Forward Contract
Forward markets world wide are afflicted with the following
problems:
11
Futures Contract
► The future contracts represent an improvisation &
provide for trading like forward contracts, but without its
attendant problems.
a) Security
b) Standardized terms and conditions
c) Liquidity
d) Competitive pricing
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Futures Contract
The contract seller is called the short and purchaser is called
the long. Both parties post a performance bond, called the
margin, that is held by the clearing association. Margin
transfers, called variation margin, are made daily in
response to a mark-to-market process based on the daily
settlement prices.
The purpose of futures contract is not to provide a means
for the transfer of goods. In other words, the property
rights to assets-real & functional-cannot be transferred
through futures contracts. Such contracts enable people to
reduce price risk that they assume in their business.
Most of the futures contracts get eliminated before the date
of maturity and only an insignificant proportion of them
result in deliveries. Most of the traders cancel their position
by taking reverse positions.
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Futures Contract
Ex. A person who took a long position in a futures contract
involving, say 100 quintals of wheat might not want to
take the delivery of the wheat and the farmer who
hedged by selling the contract might like to sell his wheat
in local market rather than deliver it at designated
delivery point. In either case, the contract can be
satisfied by making an offsetting trade. The person with
long position would sell a contract and thereby cancel his
position. Similarly the other party, the farmer with a short
position, would buy such a contract. Both the parties
would be out of this market.
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Futures Contract
Each future contract has an associated month that represent
the month of the contract delivery or final settlement.
Individual contracts are identified by their delivery months. Ex
“December Corn” , “July T-bills” so on and so forth.
All future contracts on the same underlying asset, that trade on
the same exchange and have the same delivery month are
identical and constitute a future series. Thus , all December
Corn Contracts on CBOT are part of December series in corn.
To distinguish between the two series, traders often refer to
the sooner-to-deliver contract as the front month and later-to-
deliver contract as the back month. The soonest-to-deliver
contract is often called the nearby contract. Contracts are also
distinguished by reference to the ‘less forward’ and ‘more
forward’ delivery months.
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Types of Future Contracts
► Commodity Futures: Involves a wide variety of agricultural &
other commodities including precious metals. Major future
exchanges include Chicago Board of Trade, Kansas City Board
of Trade, Chicago Mercantile Exchange, New York Commodity
Exchange , NCDEX etc and include commodities like wheat,
corn, oats, Soya bean, cotton, crude oil, silver, gold & so on.
► Financial Futures: Involves financial assets/tools as against
commodities. The first financial future came into existence in
USA with the introduction of currency future by the
International Monetary Market (IMM), a division of Chicago
Mercantile Exchange. In India financial futures are available
in BSE, NSE & MCDEX. Some of the underlying assets include
BSE Index Futures, S&P CNX Nifty Futures, futures on
individual stocks, currency futures (in India it is USD/INR with
lot size of USD 1000), Treasury papers, G-Sec etc.
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Difference between Commodity & Financial Futures
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Specifications of Future Contract
In developing a future contract, exchange must specify:
a) The asset
b) The contract size
c) The time of delivery
d) The place of delivery
e) Quotation of price
f) Alternative asset (s), if any, which may be acceptable for
delivery in lieu of particular asset, etc. It is significant
that in case alternatives are provided in the contract, the
person with short position i.e. one which sells it, is
entitled to choose between the alternatives available.
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Specifications of Future Contract
g) Quality (in case of commodities) & quantity of the asset.
h) Tick size- the minimum price change.
i) Limits within which the price would be allowed to vary on
a trading day.
j) The contract month.
k) Start of the contract year.
l) Last trading day.
m) Last delivery date.
n) Trading hours.
o) Ticker symbol to identify the asset.
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Future Contract
► An important point on which a futures contract on
commodities differ from a forward contract is that the
exact delivery date is not specified on it. In respect of
commodities, the delivery period is generally the whole
month and the holder of the short position has the right to
choose the time during the delivery period at which the
delivery would be made.
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Future Contract-23/12/08
► Margins in forward contract is a ‘performance bond’ and
not equity.
► Its function is to guarantee performance.
► Margin need not be tendered necessarily in cash.
► Larger market players meet their margin requirements with
T- bills or other forms of security.
22
Future Contract
► Future markets are markets where positions can be taken
without investment. Therefore they are also known as ‘off
balance sheet’ transactions.
23
Future Contract
► Futures are traded in exchanges similar to stock exchanges. The open
interest means the number of outstanding contracts at any point of
time.
► Open interest position does not necessarily increase with every contract
traded.
If both the parties to a contract hold positions opposite to the ones
taken in the contract then open interest position would fall by one
contract.
If none of the parties in the contract are taking an offsetting position,
then open interest position increases.
If one of the parties to the contract holds no earlier position as in
contract under position, while the other holds a position opposite to the
one held in this contract, then open position interest will not change.
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Future Contract
► In futures, clearing house is the counterparty to both
buy/sell transactions and thereby guarantee the delivery
and payment of assets.
► Apart from standing guarantee to each transaction the
clearing house does the matching, processing, registering,
confirming, settling and reconciling all the transactions.
► Margin is determined by the exchange and the clearing
house keeping in mind the expected fluctuation as
deduced from past data.
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Future Contract
Initial margin- 5-10% of the value of contract
Margin
Maintenance margin-3/4th of the initial margin
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Future Contract
Suppose there is a contract of 100 quintals of wheat which
investor has agreed to purchase at future price of
Rs.600/quintal. Then
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Future Contract
Trading Day Futures Daily G/L Cumulative Margin A/c Margin Call
Price Gain ( Loss) Balance
Sep 2 600.00
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Future Contract
► The effect of marking to market is that a futures contract
is settled daily instead of being settled at the date of
maturity and has the effect of bringing the value of the
contract back to zero.
► A future contract is closed out and rewritten at a new price
on each trading day.
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Future Contract
► Brokers are free to take greater margins, but not lower,
than determined by the future exchanges. Factors
affecting margin levels are:
Price volatility
Daily price moves permitted for the contract
Time needed to recover position losses from the
customers.
Objectives of the trade
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Divergence of Future and Spot Prices: The Basis
► The difference between the spot price and the future price
is known as the basis. Thus,
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Divergence of Future and Spot Prices: The Basis
As the delivery month approaches, the basis declines until the spot
and future prices are approximately the same. This phenomenon is
known as convergence.
If two are unequal, then arbitrage opportunity exist for traders.
If the future price is higher than the spot price then arbitrageur will
a) Short sell futures contract
b) Buy the asset
c) Make delivery to reap the profit equal to the excess of the future
price over the spot price. As the traders exploit this opportunity the
prices of future will drop.
If the future price is lower than the spot price an investor will buy a
futures contract and take the delivery.
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Expected Basis
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Expected Basis-Keynes and Hicks
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Expected Basis-Keynes and Hicks
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Expected Basis-Expectation Principle
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Basis Risk
37
Basis Risk
The key factor affecting the basis risk is the choice future
contract to be used for hedging. The choice has two
components:
1. The choice of asset underlying the future contract.
2. The choice of the delivery month.
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Basis Risk
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Basis Risk
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Basis Risk- Problem
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Basis Risk- Problem
It is June 8, and a company knows that it will need to purchase 20000 barrels
of crude oil sometimes in Oct or Nov. Oil futures are currently traded for
delivery every month on NYMEX and the contract size is 1000 barrels. The
current Dec oil futures price is $18 per barrel. The spot price and future price
on Nov 10 are $20 per barrel and $19.10 per barrel. What is the effective
price per barrel company has to pay?
Strategy: The company takes a long position in 20 NYM Dec oil futures
contract on June 8.
Closes the contract when it finds it is ready to purchase the oil.
The company was ready to purchase oil on Nov 10 and closed out its futures
contract on that date. Therefore,
Basis = $20-$19.10=0.90
Gain on future=$19.10-$18.00=$1.10
The effective cost of the oil purchased is the Nov 10 price less the gain in futures
$20-$1.10=$18.90
It can also be written as initial December future price + basis
$18.00+$0.90=$18.90
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Summary