Chapter 03

FORWARD AND FUTURES MARKETS:
PRICING AND ANALYSIS
CHAPTER 3
Chapter Objectives
• This Chapter intends to provide an examination of forwards and futures.
• On completion of this chapter you should the understanding of mechanics of

trading of forwards and futures.
• You should also have good knowledge pricing and related issues of forwards and
futures contracts.
• You should have an understanding of basic derivative structures to build on for an

in-depth study of complex structures in following chapters.
CHAPTER 3: FORWARD AND FUTURES MARKETS: PRICING AND ANALYSIS Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
3
Forward Contracts
• Variants of modern day forward contracts were present in 17th century amongst
rice farmers and dealers in Japan.
• In US and Europe, forward contracts seem to have their beginning in agriculture

based businesses.
• Agriculture has multiple factors beyond human control. Like weather, diseases, insects etc.
• All of these factors directly impact the supply chain thus the pricing.
• Price risk directly affects business planning for mills and food processing industries.
4
Forward Contracts
• Illustration:
• Assume there are two parties, a cocoa farmer who has planted crop and expects to harvest in
6 months.
• The second party is a confectioner who needs cocoa, assuming he has enough inventory for 6
months.
• Both parties are exposed to price risk:

• Cocoa farmer has a risk of spot prices falling between now and 6 months. Any decrease in prices
would result in lower profits for the cocoa farmer, or a sharp loss may result in outright loss.
• Confectioner has a risk of spot prices increasing in 6 months time. Any increment in price would
result in increased costs and reduce his profits.
5
Forward Contracts
• Illustration – Contd.
• Since both parties face a price risk, it is beneficial for them to go into an arrangement that
would protect them from this, thus a Forward Contract.
• Under the forward contract farmer would agree to deliver X amount of cocoa in 6 months.
• And the confectioner agrees to receive X amount of cocoa in 6 months.
• The price, time and quantity is agreed mutually at the initiation of contract.
• Both parties through this arrangement eliminate the uncertainty in prices.
• Forward Contract being a documented contract is legally binding
6
Forward Contracts
• Parties in a forward contract are said to have taken a long and short position.
• Long Position - Is the party that promises to take delivery, thus the confectioner.
• Short Position - Is the party that promises to make delivery, in the Illustration the cocoa
farmer.
• A forward contract is a two staged process.

• First step is negotiation and agreement at the initiation of contract.
• Second step on the maturity date when the contract is consummated and commodity and
money exchange hands.
7
Forward Contracts
8
Forward Contracts - Problems
• Forwards contracts though being easy to execute and customize, have three
inherent flaws.
• Multiple Coincidence of Needs
• Potential for Price Squeeze/Unfair Price
• Counterparty/Default Risk
• Multiple Coincidence Needs

• Amongst Counterpartys for a forward contract to take place three elements need to match.
• Asset match - Both the long and short positions want the same underlying asset
• Maturity match - Both parties need to find the maturity suitable for their needs.
• Quantity match - Both parties have similar transaction quantity need.
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• Potential for Price Squeeze/Unfair Price
• In a forward contract price is achieved through mutual negotiation.
• Bargaining position matters in negotiation. Weak bargaining position of one party can lead to
price squeezing.
• Example: If in the earlier illustration, there is only one confectioner and multiple cocoa farmers, the
confectioner has bargaining power and can dictate prices. In this case, even if the price is deemed
unfair by the cocoa farmer he would have to agree with it due to lack of any other buyer for hi
produce.
• The ‘fair’ forward price should equal the current spot price plus the cost of carrying the
underlying asset to maturity.
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• Counterparty risk or default risk, refers to the possibility that one of the parties to the
transaction could default.
• Default does not happen because of “dishonest” parties but due to incentive to default.
• In earlier illustration, at initiation a price was agreed upon. Subsequently two scenarios are
possible.
• If the prices begin to fall, the long position (confectioner) begins to hurt since he has committed to
buy at a higher price.
• If the prices begin to increase, the short position (cocoa famer) begins to hurt since he could have
sold his produce at a higher price than already committed.
11
• Illustration – Assume that in early example, the agreed forward price was RM 100 per ton.
Two plausible cases are :
• At maturity spot price is RM 70 per ton.
12
• Illustration – Assume that in early example, the agreed forward price was RM 100 per ton.
Two plausible cases are :

• Falling spot prices are favourable to short position but unfavourable to long
position.
• Rising spot prices are favourable to long position but unfavourable to short
position.
13
Futures Contracts
• Futures contracts were introduced to address the problems in Forward contracts.
• Futures contracts simply put are standardized and exchange traded forward
contracts.
• Standardization enables futures contracts to be traded on exchanges. Key features

that are standardized:
• Maturity, Quantity, Quality and Place of delivery
14
Futures Contracts
• Key features of futures contracts in comparison with forward contracts are:
15
Mechanics of Future Trading
• To understand the mechanism of Future trading we would carry on with the
earlier cocoa farmer and confectioner example.
• Assume Farmer expects to produce 120 tons of cocoa in 6 months time.
• The futures contracts are available in 3, 6, 9 and 12 months maturity with a standard size of
10 ton per contract.
• The current quoted price for 6 month cocoa future is RM 100 per ton, translating into
RM1000 per contract.
• For simplicity purposes, assume confectioner also requires 120 tons of cocoa in 6 months
time.
16
• The hedging mechanism would operate as follows.
• The cocoa farmer would call his broker and sell(short) 12 contracts of 6 month cocoa futures.
• The farmer now knows he will receive RM 12,000 (RM 1,000 x 12) in 6 months.
• The confectioner will call his broker and buy (long) 12 contracts of 6 month cocoa futures.
• The confectioner now knows he has to pay RM 12,000 (RM 1,000 x 12) in 6 months.
• Neither parties need to know who the counterparty is and are assured of the
delivery/payment of the trade.
• On registration of the trade, the clearinghouse guarantees the performance of the contract.
17
• On day 180, the contract will be settled via the following process.
18
• The mechanics of future contracts enable to overcome the problems faced by
forward contracts.
• Multiple Coincidence
• All contracts are traded on the exchange, so it becomes the focal point for all buyers and
sellers, making finding the counterparty simple.
• Standardized sizes allow divisibility, i.e. seller does not need to find a counterparty with the
exact matching quantity requirements.
19
• Unfair Pricing
• Through interaction of multiple buyers and sellers in the exchange, market clearing prices are
achieved.
• These prices would reflect currently available information and demand-supply conditions.
• Counterparty Risk
• Futures Exchange through its clearinghouse becomes the counterparty for every trade.
• Clearinghouse guarantees each trade.
• In case of default of one parties, clearinghouse stands ready to complete the trade.
20
Margining and Marking-to-Market
• The clearinghouse in guaranteeing every trade essentially transfers the default risk
on itself.
• Clearinghouse manages its own risk by means of margin and marking to market.
• Marking-to-Market process is through which the clearinghouse recognizes

gains/losses incurred by the long and short positions and adjusts their margin
accounts accordingly.
• It is done on a daily basis.
21
• Two types of margins are maintained with clearing house
• Initial Margin – It has to be deposited on the day the futures contract is entered.
• This is done since both long and short position can potentially lose with variation of prices.
• Typically 10% to 20% based on credit worthiness.
• Maintenance Margin – It is the additional margin payments that would have to be paid if the
initial margin falls below a certain level.
• It is usually a percent of the initial margin; for example 70% of initial margin.
• A margin call is a requirement that margin account be brought back to its initial margin level by
paying an additional margin.
22
• Illustration:- (Cocoa farmer and confectioner)
• At the time of initiation of contract, both parties would be required to post the initial margin
of 10 %. RM 1,200 (10% of RM 12,000).
• Maintenance Margin for both parties would be RM 840 (70% of initial margin).
• If either party’s margin balance falls below RM 840, he would receive a margin call from his
broker.
• On Day 1, the futures price falls to RM 98 per ton.

• A fall in price would profit the short position but work against the long position,
• This represents a movement of funds out of the ‘losing’ account and into the ‘gaining’ account.
• The adjustment amount would be RM 240 (RM 2.00 × (10 tons per contract × 12 contracts))
23
• RM 120 is deducted from the long position and the same amount added to the short position.
• After the deduction on day 2, the long position’s margin balance is RM 840 (RM1.200 – RM240
(Day 1) – RM 120 (Day 2))
• On Day 3, the futures price rises to RM 98 per ton.

• RM 120 is deducted from the short position and the same amount added to the long position.
24
• RM 240 is deducted from the long position and the same amount added to the short position.
• After the deduction on day 2, the long position’s margin balance is RM 720 (RM1.200 – RM240
(Day 1) – RM 120 (Day 2) + RM 120 (Day 3) - RM240 (Day 4))
• The long position will receive a margin call from his broker, requiring him to pay an additional
RM 480 (RM 1,200 – RM 720) to top up to the level of initial margin.
• This amount has to be paid within a stipulated time the next day. Failing which, the long
position would be deemed to have defaulted.
25
26
• Marking to Market is exercised to ensure players pay up their loses as they occur.
• With loses already paid for the parties would not have any incentive to default.
• Example: If the spot prices on the maturity date is RM 80 per ton. The confectioner will have
an incentive to default. Because the confectioner can buy the same product from open
market at RM 80 per ton.
• With Marking to Market on daily basis he would have paid RM 2,400 (RM 20 per ton) to the
margin account. The confectioner would have to pay RM 80 per ton at maturity to take
delivery of the cocoa.
27
Forwards, Futures: Zero Sum Game
• Futures and Forwards, enable the hedger to lock-in the price he would pay or
receive.
• By locking in the prices, a hedger will not be able to take advantage of favourable
price movements.
• In our example, Cocoa farmer after entering into a forward or a future contract cannot benefit
from a higher spot price.
• The counterparties make an implied loss and gain due to price fluctuation.
• In our example if spot prices rise to RM110 per ton, the implied loss of the cocoa farmer is
RM 10 per ton. At the same time the confectioner makes an implied gain of RM 10 per ton.
28
Forwards, Futures: Zero Sum Game
• Notice that the implied gain of the confectioner is equal to the implied loss of the
farmer.
• In a world of limited/finite resources, most financial transactions, including all

derivatives transactions are zero-sum games, that is, one party’s gain is at another
party’s expense.
• The implied gains can be summarized as:

• If spot prices rise: Profit to long = spot price at maturity – Original futures price (The short
position’s implied loss equals this amount)
• If spot prices fall: Profit to short = Original futures price – Spot price at maturity (The long
position’s implied loss equals this amount)In our example, Cocoa
29
Main Players in Futures Market
• Hedgers
• Hedgers use futures contracts to manage their price risk.
• They are typically businesses that use derivatives to offset exposures resulting from their
business activities.
• Example: In our continuing example, once the cocoa farmer has planted cocoa, he is “long” in
cocoa, since he is committed to produce it. He is now exposed to price risk. To offset that risk
he takes a “short” position in cocoa futures.
30
• Hedgers
• Hedgers use futures contracts to manage their price risk.
• They are typically businesses that use derivatives to offset exposures resulting from their
business activities.
• Example: In our continuing example, the confectioner needs cocoa in six months time, so he is
“short” in cocoa. To offset that risk he takes a “long” position in cocoa futures.
31
• Hedgers
• What is the correct hedging strategy?
• There are two equivalent ways to determine the appropriate hedge position.
• View from the underlying asset position: This is if you are long the underlying asset, then the
position in a futures contract of the same underlying asset should be short and vice versa.
• View from price risk : To protect yourself from rising prices of the underlying asset, long the futures
contract. To protect against falling prices, short the futures contract.
• One who would be long in an asset now, would be afraid of falling asset prices and would go short
to hedge and vice versa.
32
• Hedgers
• What is the correct hedging strategy?
• There are two equivalent ways to determine the appropriate hedge position.
• View from the underlying asset position: This is if you are long the underlying asset, then the
position in a futures contract of the same underlying asset should be short and vice versa.
• View from price risk : To protect yourself from rising prices of the underlying asset, long the futures
contract. To protect against falling prices, short the futures contract.
• One who would be long in an asset now, would be afraid of falling asset prices and would go short
to hedge and vice versa.
• An Anticipatory hedge is when a producer anticipates having a position in the underlying

asset at a future point and want to hedge against it.
33
• Arbitrageurs
• Arbitrageurs, use derivatives to engage in arbitrage.
• Arbitrage is the process of trying to take advantage of price differentials across different
markets
• Arbitrageurs closely follow quoted prices of the same asset/instruments in different markets
looking for price divergences. Should the divergence in prices be enough to make profits, they
would buy in the market with the lower price and sell in the market where the quoted price is
higher.
• Since all financial markets are integrated via computer networks, arbitrage boils down to
hitting the right keystrokes.
34
• Arbitrageurs
• Arbitrage opportunities can quickly disappear thus require quick actions.
• Banks utilize, computers that are programmed to track in real time prices in different markets,
identify arbitrage opportunities and use the right arbitrage strategy.
• Since the underlying asset is the same, a given pricing relationship should hold between the
spot and futures. Once this pricing relationship is violated, riskless arbitrage is possible.
• The arbitrage strategy for spot- future mispricing are:
35
• Speculators
• They are players who establish positions based on their expectations of future price
movements.
• Example: If speculators expect the underlying asset’s price to rise over the immediate future, they
would long futures contracts on that asset.
• Unlike hedgers and arbitrageurs, speculators take positions in assets or markets without
taking offsetting positions.
• Speculators can be classified as:

• Day Trader: Day trader does mostly intra-day trading and on relatively small volumes.
• Scalper: Scalper is essentially similar to day trader but takes large volume positions on small mispricing.
• Position Trader: Position trader is a relatively longer term player. He often takes and hold positions of
several weeks/months before getting out.
36
Determination of Futures Prices
• How are Futures Contract priced?
• A derivative derives its value from its underlying asset.

• The starting point would be the spot price of underlying asset.
• Futures price has to be determined by adjusting the spot price of the underlying asset by the
carrying cost.
• Since a futures contract calls for delivery at a future date, the short position (seller) will have
to incur additional costs like storage and handling costs, etc.
• Since the payment for the futures will be received only at maturity the short position also
incurs the opportunity cost of later payment
37
• With the stated logic, the price determination of futures is based on the current
spot price of the underlying asset adjusted for costs.
• Cost of storage which includes the costs of handling, spoilage, shrinkage etc.,
• The opportunity cost of having to receive payment only at maturity of the futures contract.
• The price needs to adjust for “Convenience Yield”.

• Convenience yield refers to any benefits that could accrue to the short position (seller) from
holding onto the spot asset until maturity.
38
• Cost of Carry Model (COC).
Ft,T = So(1 + rf + c – y)t,T
• Ft,T = futures price for a contract with maturity from t to T (t = today, T = maturity)
• So = current spot price of the underlying asset
• rf = annualized risk free interest rate (being the proxy for the opportunity cost of later payment)
• c = annualized storage cost in percent (inclusive of shipping handing, shrinkage, spoilage etc.)
• y = convenience yield (annualized percentage)
39
Cost of Carry Model - Example
• For our Example of Cocoa farmer and confectioner, the following information is
given:
• Spot price of cocoa = RM 98.00 per ton
• Risk free interest rate (rf) = 6% annualized
• Storage cost = RM 5.00 per ton/year
• Convenience yield to farmer = nil
• The correct price of a 180-day (6-month) futures contract according to the cost of
carry model is RM 103.30.
40
Cost of Carry Model - Example
• Cost of Carry Model Calculation
Ft,T = So(1 + rf + c – y)t,T

F180= RM 98 (1 + 0.06 + 0.051 – 0)0.5
= RM 98 (1.111)0.5
= RM 98 (1.054040)
= RM 103.30
• The storage cost of RM 5.00 per ton per year is entered as a percentage in the equation.
• The equation is raised to the power of 0.5. This is to denote the 6-month or half-year
period.
41
Issues in Future Trading
• Convergence Property
• Convergence property states that the price of a futures contract on the day of its maturity
must equal the spot price of the underlying asset on that day.
• The logic is that, on its maturity day, a futures contract is essentially a spot asset since there
are no carrying costs or convenience yield.
• According to this property, convergence should occur only at maturity.
• The logic is, that even though the underlying asset is the same, the spot and futures prices
should not be the same since there is clearly a time difference between the two.
• This time difference brings into play the earlier mentioned opportunity costs, storage costs, etc.
42
• Convergence Property
43
• Basis and Basis Risk
• The difference or spread between the futures and spot prices is often known as the basis.
• Going by equation Carry Cost Model, the basis should equal the net carrying cost.
• Basis risk can be thought of as tracking error. Such a tracking error happens when there are
mismatches.
• Asset mismatch : When underlying asset of the futures contract and spot is different.
• Maturity mismatch: A maturity mismatch happens when the hedging horizon does not match
contract maturity.
• Quantity (or contract size) mismatch: A quantity mismatch might mean that either you overhedge
or underhedge.
44
• Cross Hedging
• Cross-hedging refers to the use of a futures contract with an underlying asset different from
that of the asset to be hedged.
• Cross Hedging happens when the underlying asset does not have a futures contract.
• Instead of leaving the position unhedged, organizations would go for a future contract which
has the highest correlation with the underlying asset.
• Since, almost no two asset returns could be perfectly correlated, crosshedging would always
be exposed to some degree of basis risk.
45
• Leverage and Transaction Costs
• Futures contracts and derivatives in general have lower transaction costs.

• Example: In Malaysia, transaction cost of using Stock Market and Index futures is substantially
lower, the than spot market.
• Derivatives have inbuilt leverage.

• Leverage refers to the use of other people’s money (OPM) in the financing of an asset.
• Futures contracts have inbuilt leverage since one need only pay the initial margin and not the full
amount.
• Example: In our example, the confectioner was required to pay only 10% of the price, RM 1.200
instead of the full price.
46
• Margins and Leverage Factor
• Initial margin and the extent of leverage are inversely related. The higher the initial margin, the
lower is the leverage factor or leverage multiple.
• Example: If the initial margin is 10%, the leverage factor will be 10 times. A trader in futures could
therefore control 10 times the value of the underlying asset This means that his percentage returns
would be 10 times more than that in the spot market.
• To control speculative activity the exchange can increase the initial margin.
• There exists a tradeoff for exchange, while raising margins can dampen speculative activity, it
would at the same time also hurt hedgers.
• Exchanges now use risk based margining.

• Where a futures contract is designated to have risk–based margining, the exchange is allowed to
increase margin at times of abnormal volatility in underlying asset markets
47
• Contango and Normal Backwardation
• Contango and backwardation refer to the pattern of prices between the spot and futures
contracts.
• When the futures price is higher than the spot price and the distant futures contracts have
higher prices than nearby contracts, the prices are said to be in contango formation.
• Backwardation is the opposite situation. Backwardation occurs when the futures price is
lower than the spot price and the distant futures are priced lower than the nearby futures.
• Such formations are formed due to expectations.

• Example: When the market expects increased supply of a commodity in the future or decreased
demand, one would see backwardation.
48
• Open Interest and Trading Volume
• Open interest and trading volume are indicators of how active trading in a futures contract is.
• Daily trading volume is the aggregate of total trade in a particular contract. While Open
interest is the total number of outstanding contracts for a particular contract month.
• Open interest is a more meaningful item where derivatives are concerned.

• Week 1: Trader A longs the contract while Trader B goes short. The trading volume rises by 2 since
there are two transactions. However, the open interest only increases by 1. Open Interest is 1 since
measured from either the total of long positions or total short positions, open interest only
increases by one.
• Week 2: Trader A offsets his long position by going short (selling) to Trader C. The trading volume
rises by 2 while open interest would be unchanged. Open interest is unchanged since neither the
total of long nor short positions have changed.
49
Types of Orders
• Orders can be categorized into three categories according to their nature:
• Price related orders
• Execution related orders
• Time related orders
• Price Related Order

• Market Order: It requires the broker to buy or sell at prevailing market price.
• Limit Order or Price Order: A trader specifies the price at which he wants the transaction to
be executed.
• Stop Order: A stop order may be either a buy-stop order or a sell-stop order.
• A buy-stop order is an order instructing a broker to buy at a specified price above the market price.
• A sell-stop order is where a trader instructs the broker to sell at a price lower than the current
market price.
50
Types of Orders
• Execution Related Order
• Market If Touched Order (MIT) : An MIT order is a specific order to a broker to buy or sell if
and only if the market price hits a certain price.
• Example: Suppose I place an MIT order to buy June CPO at RM 980; the broker will do nothing until
the market price of June CPO futures hits RM 980. Then he would start to fill my order.
• Market on Close (MOC), Market On Open (MOO) Orders:

• A Market On Open Order is an instruction to a broker to either buy or sell at the market opening
price.
• A Market On Close Order is an instruction to transact at the last minute, such that the transaction
price will be the closing price.
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Types of Orders
• Time Related Orders
• Fill or Kill (FOK) Order: A fill or kill order is an instruction to a broker to either buy or sell
immediately or cancel the order.
• Good till Cancelled Order (GOC): A GOC remains active either until it is filled by the broker or
is cancelled by the trader.
• One-Cancels-the-Other Order (OCO): An OCO order is used when a trader wants to catch a
price breakout on either side.
• An OCO is essentially two orders placed simultaneously but with the stipulation that if one order is
filled the other must be automatically cancelled.
• Day Order: It is an instruction to a broker to transact at a specified price within the day.
52
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FORWARD AND FUTURES MARKETS:

PRICING AND ANALYSIS

• On completion of this chapter you should the understanding of mechanics of

• You should have an understanding of basic derivative structures to build on for an

• In US and Europe, forward contracts seem to have their beginning in agriculture

• Both parties are exposed to price risk:

• And the confectioner agrees to receive X amount of cocoa in 6 months.

• Both parties through this arrangement eliminate the uncertainty in prices.

• Forward Contract being a documented contract is legally binding

• A forward contract is a two staged process.

• Potential for Price Squeeze/Unfair Price

• Multiple Coincidence Needs

• At maturity spot price is RM 70 per ton.

• Standardization enables futures contracts to be traded on exchanges. Key features

• Maturity, Quantity, Quality and Place of delivery

• Clearinghouse guarantees each trade.

• Marking-to-Market process is through which the clearinghouse recognizes

• It is done on a daily basis.

• Typically 10% to 20% based on credit worthiness.

• On Day 1, the futures price falls to RM 98 per ton.

• On Day 3, the futures price rises to RM 98 per ton.

• In a world of limited/finite resources, most financial transactions, including all

• The implied gains can be summarized as:

• An Anticipatory hedge is when a producer anticipates having a position in the underlying

• The arbitrage strategy for spot- future mispricing are:

• Speculators can be classified as:

• A derivative derives its value from its underlying asset.

• The price needs to adjust for “Convenience Yield”.

• Cost of Carry Model (COC).

Ft,T = So(1 + rf + c – y)t,T

• Spot price of cocoa = RM 98.00 per ton

• Risk free interest rate (rf) = 6% annualized

• Storage cost = RM 5.00 per ton/year

• Convenience yield to farmer = nil

Ft,T = So(1 + rf + c – y)t,T

• According to this property, convergence should occur only at maturity.

• Futures contracts and derivatives in general have lower transaction costs.

• Derivatives have inbuilt leverage.

• Exchanges now use risk based margining.

• Such formations are formed due to expectations.

• Open interest is a more meaningful item where derivatives are concerned.

• Price Related Order

• Market on Close (MOC), Market On Open (MOO) Orders:

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