An Overview of

Forward and Futures Trading

• Forward contracts are negotiated directly between
two parties in the OTC markets.
• Individually designed to meet specific needs
• Subject to default risk
• Futures contracts are bought through brokers on an
exchange
• No direct interaction between the two parties
• Exchange clearinghouse oversees delivery and settles
daily gains and losses
• Customers post initial margin account
• See Exhibits 1 and 2
21-1
Exhibit 1

21-2
Exhibit 2

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An Overview of
Forward and Futures Trading
• Futures Contract Mechanics
• Futures exchange requires each customer to post an
initial margin account in the form of cash or government
securities when the contract is originated
• The margin account is marked to market at the end of
each trading day according to that day’s price movements
• Forward contracts may not require either counterparty to
post collateral
• All outstanding contract positions are adjusted to the
settlement price set by the exchange after trading ends

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An Overview of
Forward and Futures Trading
• With commodity futures, it usually is the case that
delivery can take place any time during the month at the
discretion of the short position
• See Exhibit 3 for futures quotations
• Comparing Forward and Futures Contracts
Futures Forwards
Design flexibility: Standardized Can be customized
Credit risk: Clearinghouse risk Counterparty risk
Liquidity risk: Depends on trading Negotiated exit

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Hedging With Forwards and Futures
• Hedging and the Basis
• Create a position that will offset the price risk of another
more fundamental holding
• A short hedge: Holding a short forward position against the
long position in the commodity
• A long hedge: Supplements a short commodity holding with a
long forward position
• The basic premise behind any hedge is that as the price
of the underlying commodity changes, so too will the
price of a forward contract based on that commodity

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Hedging With Forwards and Futures
• Defining the Basis
• Basis is spot price minus the forward price for a contract
maturing at date T:
Bt,T = St - Ft,T
where
St the Date t spot price
Ft,T the Date t forward price for a contract maturing at Date T

• Initial basis, B0,T, is always known

• Maturity basis, BT,T, is always zero. That is, forward and
spot prices converge as the contract expires
• Cover basis: Bt, T

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Hedging With Forwards and Futures
• Understanding Basis Risk
• The terminal value of the combined position is defined
as the cover basis minus the initial basis
Bt, T – B0, T = (St - Ft,T ) - (S0 – F0,T )

• Basis Risk
• Investor’s terminal value is directly related to Bt, T
• Bt, T depends on the future spot and forward prices
• If St and Ft,T are not correlated perfectly, Bt, T will change and
cause the basis risk
• Hedging Exposure
• It is to the correlation between future changes in the spot and
forward contract prices
• Perfect correlation with customized contracts
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Hedging With Forwards and Futures
• Calculating the Optimal Hedge Ratio
• Net profit from the position
P t = (S t - S 0)-(Ft ,T - F0 ,T )
(N)= (DS)-(DF)(N)
• The variance of this value
s t2,T = s D2S + N 2 s D2F - 2(N)COVDS,DF
• Minimizing the variance and solve for N

COVDS, DF æ s DS ö
N =
*
=çç ÷
÷ p
s DF
2
è s DF ø
where: ρ= the correlation coefficient between the spot and
forward price changes
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Basic Valuation Concepts

• Valuing Forwards
• Suppose that at Date 0 you contracted in the forward market to buy Q ounces
of gold at Date T for F0,T.
• That is, at Date t you would agree to sell Q ounces of gold at Date T for the
price of Ft,T.
• The Date t value of a long forward contract maturing at Date T
Vt ,T = (
Q [Ft ,T - F0,T]¸ 1 + i)(T -t)

where: i the appropriate annualized discount rate

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Basic Valuation Concepts

• Valuing Futures
• Valuing a futures contract is conceptually similar to
valuing a forward contract with one important difference
• Futures contracts are marked to market on a daily basis
and this settlement amount was not discounted
• The Date t value of a long futures contract maturing at
Date T

V
*
t ,T (
= Q F * t ,T - F * 0 ,T )
* = the possibility that forward and futures prices for the same
commodity at the same point in time might be different 21-11
Basic Valuation Concepts

• The Relationship Between Spot and Forward Prices

• If you buy a commodity now for cash and store it until
you deliver it, the price you want under a forward
contract would have to cover: (1) the cost of buying it
now, S0 (2) the cost of carry, SC0, T
• The Cost of Carry
• Commissions paid for storing the commodity, PC0,T
• Cost of financing the initial purchase, i0,T
• Cash flows received between Dates 0 and T, D0,T
F0,T = S 0 + SC0,T = S 0 +(PC0,T + i0,T - D0,T )
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Basic Valuation Concepts
• Contango Market
• When F0,T > S0
• Normally with high storage costs and no dividends
• Backwardation Market
• When F0,T < S0
• Normally with no storage costs and pays dividends
• Premium for owning the commodity
• Convenience yield
• Can results from small supply at date 0 relative to what is
expected at date T (after the crop harvest)

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Financial Forwards and Futures:
Applications and Strategies
• Interest rate forwards and futures were among the
first derivatives to specify a financial security as the
underlying asset
• Forward rate agreements
• Interest rate swaps
• Basic Types
• Long-term interest rate futures
• Short-term interest rate futures
• Stock index futures
• Currency forwards and futures

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Long-Term Interest Rate Futures
• Treasury Bond and Note Contract Mechanics
• The U.S. Treasury bond and note contracts at the
Chicago Board of Trade (CBT) are among the most
popular of all the financial futures contracts
• Exhibit 21.6 shows a representative set of quotes for
these contracts
• Expiration date: March, June, September, December
• Contract size: $100,000
• Prices quoted in 32nds
• Delivery date: Any day during the month of maturity
• The cheapest to deliver and the conversion factors for
differences in deliverable bonds

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Exhibit 6

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 Long-Term Interest Rate Futures
• A Duration-Based Approach to Hedging
• The optimal hedge ratio

æ DS ö
ç ÷
* D S è S ø S - Dmod S ´ D(iS n) S
N = = ´ = ´
S æ DF ö F - Dmod F ´ D(iF n) F
ç ÷
è F ø
- D mod S S
or
*
N = ´ bi ´
- D mod F F

where: βi = the “yield beta”

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n is the number of payment periods per year
 Long-Term Interest Rate Futures
• Treasury Futures Applications
• Hedging a Future Funding Commitment
• Take a short position in the futures market
• The futures will appreciate in value if interest rates increase,
offsetting the higher payments required on the underlying debt
when interest rate increases
• A T-Bond/T-Note (NOB) Futures Spread
• Expecting a change in the shape of the yield curve
• Unsure which way rates will change
• Long one point on curve and short another point

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Short-Term Interest Rate Futures
• Eurodollar Contract Mechanics
• The Eurodollar contract traded on the Chicago Mercantile
Exchange (CME)
• The contract nominally requires the long position to
make, and the short position to receive, a 90-day Euro-
time deposit
• The underlying interest rate is
• the 3-month (i.e., 90-day) LIBOR
• Exhibit 7 shows a representative set of quotes
• Expiration dates
• Contract size
• Settlement price
• Open interest

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Exhibit 7

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Short-Term Interest Rate Futures
• Short-Term Interest Rate Future Applications
• Creating a synthetic fixed-rate funding with a Eurodollar
strip
• Making a variable LIBOR loan over the next year
• Using the Eurodollar futures market to hedge the exposure of
declining LIBOR rates
• Creating a TED (Treasury/EuroDollar) spread
• Long TED Spread = (Long T-Bill Futures)
+(Short Eurodollar Futures)
• Short TED Spread = (Short T-Bill Futures)
+ (Long Eurodollar Futures)
• A long position in a TED spread will gain when the credit spread
increases; vice versa

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Stock Index Futures
• Stock Index Futures Contract Fundamentals
• Stock index futures are intended to provide general
hedges against stock market movements and can be
applied to a portfolio or individual stocks
• Hedging an individual stock with an index isolates the
unsystematic portion of that security’s risk
• Stock index futures can only be settled in cash, similar to
the Eurodollar (i.e., LIBOR) contract
• Stock Index Arbitrage:
• Use the stock index futures to convert a stock portfolio into
synthetic riskless positions
• Prominent in program trading
• See Exhibit 9

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Exhibit 9

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Stock Index Futures
• A Stock Index Futures Application
• Isolate the unsystematic risk of an individual stock
• Have 75,000 shares of Pharmco stock at $46.75
• The company’s beta is 0.99
• Sell the S&P 500 futures contracts at 1,271.10 with an implied
value of a single contract of $317,775
• The optimal hedge ratio formula
N* = [Market Value of Spot Position
/ Value Implied by Futures Contract] β
= [($3,506,250) ÷ ($317,775)](0.99) = 10.92
• Short 11 contracts

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 Currency Forwards and Futures

• The Mechanics of Currency Transactions

• The market for foreign currency is no different than any other market, in that
buyer and seller negotiate for the exchange of a certain amount of a
predetermined commodity at a fixed cash price
• The challenge in FX transactions is that the “commodity” involved is someone
else’s currency
• Direct (American) quote in U.S. dollars
• Indirect (European) quote in non-U.S. currency
• Exhibit 14 lists quotes for a sample of currency futures contracts at the CME

21-25
Exhibit 14

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Currency Forwards and Futures
• Interest Rate Parity & Covered Interest Arbitrage
• Interest rate parity shows the condition of “no arbitrage”
relationship between spot and forward FX rates and the
level of interest rates in each currency
• Exhibit 15 presents the two investment strategies that
illustrates the framework in which how a riskless arbitrage
works
• Covered interest arbitrage is the one in which arbitrageur
will always hold the security denominated in the currency
that is the least expensive to deliver in the forward market

21-27
Exhibit 15

21-28
 Currency Forwards and Futures
• Interest Rate Parity Formula

æ æ T öö
ç 1 + (RFR FC )ç ÷÷
F0, T è 365 ø ÷
=ç
S0 ç æ T ö÷
ç1 + (RFR USD )ç ÷÷
è è 365 øø
where:
T = the number of days from the joint settlement of the
futures and cash positions until they mature
RFRUSD = the annualized risk-free rate in the United States
RFRFC = the annualized risk-free rate in the foreign market
F0, T and S0 = the forward and spot rates are in indirect quote
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 Currency Forwards and Futures
• A Currency Futures Application
• Calculating Implied World Investment Rates
• You wanted to invest in British sovereign-issued paper over the
next 163 days
• The forward rate and the spot rate are 2.0383 and 2.0296
respectively
• U.S. T-Bill has a yield of 4.15%
• Computing the investment rate
Implied Rate
= [(Spot/Futures) (1+ RFRUSD (163/365))-1] (365/163)
= [(2.0383/2.0296)(1+0.0415 (163/365))-1] (365/163)
= 5.13%

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