Forward contract and hedging

Introduction

 Like options, forward and futures contracts are derivative

securities.
 Recall, a derivative security is a financial security that is a claim
on another security or underlying asset.
 We will examine the specifics of forwards and futures and
see how they differ from options.
 Derivatives can be used to speculate on price changes in
attempts to gain profit or they can be used to hedge
against price changes in attempts to reduce risk. In both
cases, we will compare strategies using options versus
using futures.

2
Forward and Futures Contracts
 Both forward and futures contracts lock in a price today
for the purchase or sale of something in a future time
period
 E.g., for the sale or purchase of commodities like gold, canola, oil,
pork bellies, or for the sale or purchase of financial instruments
such as currencies, stock indices, bonds.
 Futures contracts are standardized and traded on formal
exchange; forwards are negotiated between individual
parties.

3
Example of using a forward or futures
contract
 COP Ltd., a canola-oil producer, goes long in a contract
with a price specified as Rs.395 per metric tonne for 20
metric tonnes to be delivered in September.
 The long position means COP has a contract to buy the
canola. The payment of Rs.395/tonne ● 20 tonnes will be
made in September when the canola is delivered.

4
Futures and Forwards – Details
 Unlike option contracts, futures and forwards commit both
parties to the contract to take a specified action
 The party who has a short position in the futures or forward
contract has committed to sell the good at the specified
price in the future.
 Having a long position means you are committed to buy the
good at the specified price in the future.

5
More details on Forwards and Futures
 No money changes hands between the long and short parties
at the initial time the contracts are made
 Only at the maturity of the forward or futures contract will
the long party pay money to the short party and the short
party will provide the good to the long party.

6
Institutional Factors of Futures Contracts
 Since futures contracts are traded on formal exchanges,
margin requirements, marking to market, and margin calls
are required; forward contracts do not have these
requirements.
 The purpose of these requirements is to ensure neither
party has an incentive to default on their contract.
 Thus futures contracts can safely be traded on the exchanges
between parties that do not know each other.

7
The initial margin requirement
 Both the long and the short parties must deposit money in
their brokerage accounts.
 Typically 10% of the total value of the contract

 Not a down payment, but instead a security deposit to

ensure the contract will be honored

8
Initial Margin Requirement – Example
 Manohar has just taken a long position in a futures
contract for 100 ounces of gold to be delivered in January.
Magda has just taken a short position in the same
contract. The futures price is Rs.380 per ounce.
 The initial margin requirement is 10%
• What is Manohar’s initial margin requirement?

• What is Magda’s initial margin requirement?

9
Marking to market
 At the end of each trading day, all futures contracts are

rewritten to the new closing futures price.

 I.e., the price on the contract is changed.

 Included in this process, cash is added or subtracted from the

parties’ brokerage accounts so as to offset the change in the

futures price.
 The combination of the rewritten contract and the cash addition or
subtraction makes the investor indifferent to the marking to market
and allows for standardized contracts for delivery at the same time to
trade at the same price.

10
Marking to market example
Consider Manohar (who is long) and Magda (who is short) in the contract for 100
ounces of gold. At the beginning of the day, the contract specified a price of
Rs.380 per ounce At the end of the day, the futures price has risen to Rs.385
so the contracts are rewritten accordingly.
 What is the effect of marking to market for Manohar (long)?

 What would be the effect on Magda (short)?

 Who makes the marking to market payments or withdrawals from Manohar’s

and Magda’s brokerage accounts?

 How does marking to market affect the net amount Manohar will pay and Magda

will receive for the gold?

 What would have happened if the futures price had dropped by Rs.10 instead of

rising by Rs.5 as described above? 11

Recap on Marking to Market

 After marking to market, the futures contract holders essentially

have new futures contracts with new futures prices
 They are compensated or penalized for the change in
contract terms by the marking to market
deposits/withdrawals to their accounts.
•

12
Why have marking to market?
 To reduce the incentive to default
 Discussion:

13
 The dreaded Margin Call

 In addition to the initial margin requirement, investors are

required to have a maintenance margin requirement for their
brokerage account
 typically half of the initial margin requirement % or 5% of the value of
the futures contacts outstanding.
 Marking to market may result in the brokerage account balance
rising or falling. If it falls below the maintenance margin
requirement, then a margin call is triggered.
 The investor is required to bring the account balance back to the initial
margin requirement percentage.

14
Margin Call Example
 Consider Manohar’s initial margin requirement, the
futures price increased to Rs.385 at the end of the first day
and now the futures price decreased to Rs.350.
 What are the cumulative effects of marking to market?
 If the maintenance margin requirement is 5% of Rs.350/ounce x
100 ounces, what will be the margin call to bring the account back
to 10% of Rs.350/ounce x 100 ounces?
 What does the margin call mean?

15
Offsetting Positions

 Most investors do not hold their futures contracts until maturity

 Instead over 95% are effectively cancelled by taking an
offsetting position to get out of the contract.
• E.g., Manohar (who was long for 100 ounces) can now
enter into another contract to go short for 100 ounces
– The two contracts cancel out
– There is no more marking to market or margin calls
– Manohar may withdraw the remaining money in his brokerage account.

16
The Spot Price
 The price today for delivery today of a good is called the spot
price.
 As a futures contract approaches the delivery date, the futures
price approaches the spot price, otherwise an arbitrage
opportunity exists.

17
Hedging with Futures
 For some business or personal reason, you either need to
purchase or sell the underlying asset in the future.
 Go long or short in the futures contract and you effectively
lock in the purchase or sale price today. The net of the
marking to market and the changes in futures prices
results in you paying or receiving the original futures price
 I.e., you have eliminated price risk.

18
Hedging Example: Farmer Brown

 Farmer Brown just planted her crop of canola and is concerned

about the price she will receive when the crop is harvested in
September.
 What is her main concern?

 How can she hedge with futures?

 How can she hedge with options?


19
Compare Hedging Strategies
(assuming contracts on one metric tonne of canola)

Derivative Used: Short Futures Long Put Option,

Contract @ E=Rs.395
Rs.395
Initial Cost Rs.0 -Rs.15
Net amount received at harvest (final payoff net of initial
cost) given final spot prices below:
Spot = Rs.320 Rs.395 Rs.380
Spot = Rs.380 Rs.395 Rs.380
Spot = Rs.440 Rs.395 Rs.425
Spot = Rs.500 Rs.395 Rs.485
20
Hedging: Futures versus Options

Net Price Received for Canola using

Different Hedging Strategies

$500
Net Amount
Received

$475
$450
$425
$400
$375
$350
$325
$0 $100 $200 $300 $400 $500
Spot Canola Price at Harvest Time

21
Hedging – Self Study
 Work through COP’s hedging strategy (from slide 5) using
futures or options. Assume the price of the relevant option with
E = Rs.395 is Rs.20.

22
Speculating with Futures
 Speculating involves going long (or short) in a futures contract
when the underlying asset is NOT needed to be purchased (or
sold) in the future time period.
 Enter into the contract, profit or lose due to futures price
changes and marking to market, do an offsetting position to
get out of the contract and take the money from the
brokerage account.

23
Speculating Example
 Zhou has been doing research on the price of gold and thinks it is
currently undervalued. If Zhou wants to speculate that the price will rise,
what can he do?
 Give a strategy using futures contracts.
 Zhou can take a long position in gold futures; if the price rises as he
expects, he will have money given to him through the marking to
market process, he can then offset after he has made his expected
profits.
 Give a strategy using options.
 Zhou can go long in gold call options. If gold prices rise, he can either
sell his call option or exercise it.

24
Compare Speculating Strategies
(assuming contracts on one troy ounce of gold)

Derivative Used: Long Futures Long Put Option,

Contract @ E=Rs.310
Rs.310
Initial Cost Rs.0 -Rs.12
Net amount received (final payoff net of initial cost) given
final spot prices below:
Spot = Rs.280 -Rs.30 -Rs.12
Spot = Rs.300 -Rs.10 -Rs.12
Spot = Rs.320 Rs.10 -Rs.2
Spot = Rs.340 Rs.30 Rs.18
Spot = Rs.360 Rs.50 Rs.38 25
Speculating: Futures vs. Options

Net Profit Received from Speculating in

Gold

$100
$75
$50
Speculating
Profit from

$25
$0
-$25
$200

$225

$250

$275

$300

$325

$375

$400
$350
-$50
-$75
-$100
-$125
Final Spot Price of Gold
26
Should hedging or speculating be done?
 Speculating: If the market is informationally efficient, then the NPV
from speculating should be 0.
 Hedging: Remember, expected return is related to risk. If risk is hedged
away, then expected return will drop.
 Investors won’t pay extra for a hedged firm just because some risk is
eliminated (investors can easily diversify risk on their own).
 However, if the corporate hedging reduces costs that investors cannot
reduce through personal diversification, then hedging may add value for
the shareholders. E.g., if the expected costs of financial distress are
reduced due to hedging, there should be more corporate value left for
shareholders.

27
Functions of futures markets
 Hedging
 Speculation
A B

State 1 2 6

State 2 3 4

 Motive for hedging

Financial Derivatives 28
Hedging cannot…
 Guarantee the best outcome

Financial Derivatives 29
What risks?
 Price risk
 Quantity risk

Financial Derivatives 30
Defns..

 A Short (or selling) Hedge: Occurs when a firm holds a long

cash position and then sells futures/forward contracts for

protection against downward price exposure in the cash
market.
 A Long (or buying) Hedge: Occurs when a firm holds a

short cash position and then buys futures/forward

contracts for protection against upward price exposure in
the cash market. Also known as an anticipatory hedge.

Financial Derivatives 31
Defns..
 A Cross Hedge: Occurs when the asset underlying the
futures/forward contract differs from the product in the cash
position.

Financial Derivatives 32
Hedge position?
 Hedging typically involves taking a position in a futures market
that is opposite to the position already held in a cash market.
 Why opposite position?

Financial Derivatives 33
When will a short hedge be beneficial?
 When the spot prices fall by the maturity date of the future
contract

Financial Derivatives 34
When will a long hedge be beneficial?
 When the spot prices rise by the maturity date of the future
contract

Financial Derivatives 35
Classic example of hedging
A cotton farmer expects 5000 kg of harvest in early January
 spot price (1 kg) Rs. 2.30
 futures price is Rs. 2.50
 Delivery after 3 months
Problem: Farmer doesn’t know what will be the price of cotton
when his crop arrives to the market and the total value of the
harvest.
Can Futures market help him???

Financial Derivatives 36
Example contd..

 Hedge using futures:

• What position should farmer take (long or short)?

 To find out, answer the following question:

• What is the farmer’s concern? (price rise or decline?)

 Take a position that earns a profit when prices move

against the entity.
• Contract size = 1,000 kg.
• long or short? 5 futures contracts.

 Loss on spot transaction (receivable) is offset by gain on

futures transaction (and vice versa).
• Enables the seller to lock in a fixed price for wheat.

Financial Derivatives 37
Example contd..
Spot declines to Rs. 2.15
 What is the farmer’s revenue?
(1) Spot market transaction:
• Rs. 10750 revenue (2.15*5000)
(2) Futures market transaction:
• A gain of Rs.1,750 {(2.50-2.15)*5000}.

Total revenue = 10750+1750 = Rs.12500

Exactly the same as reflected in the futures prices of early Jan

Financial Derivatives 38
Example contd..
Spot prices rise to Rs. 2.65
 What is his revenue?
(1) Spot market transaction:
• Rs. 13250 (2.65*5000)
(2) Futures market transaction:
• Loss of Rs. 750{(2.50-2.65)*5000}.

Total revenue = 13250-750 = Rs. 12500

Revenue = Rs. 12,500

Financial Derivatives 39
Hedge outcome

The farmer’s position in the futures market completely removed

price risk come what may he is assured of a price of Rs.2.50/kg

Financial Derivatives 40
Perfect hedges

The farmer’s position in the futures market completely removed

price risk but rarely we will find such perfect hedges.

Financial Derivatives 41
Perfect Hedge is to be found…
 …Japanese Garden
 The underlying to be hedged may not have a futures contract
trading
 The hedger is not sure of the date on which hedge will be lifted

Therefore in practice hedges eliminate some, but not all of the

price risk and this leads to basis risk

Financial Derivatives 42
Basis
Basist = cash pricet - futures pricet
bt = St - Ft

Financial Derivatives 43
 Basis for 29 Jul 2006 Nifty future's contract

100
80
Niftyindexpoints

60
40 basis
20
0
-2024- 13- 3-May- 23- 12- 2-Jul-
Mar-06 Apr-06 06 May-06 Jun-06 06

Financial Derivatives 44
 The power of basis

• What will be the gain/loss of a hedger’s position:

Total Gain / Loss  ( S1  S 0 )  ( F1  F0 )

Gain/Loss on Gain/Loss on
spot position futures
Shuffling a bit position

Total Gain / Loss  ( S1  F1 )  ( S0  F0 )

Basis at t = 1 Basis at t = 0
Total Gain / Loss  b1  b0
b1 is a random
b0 is known
variable

Financial Derivatives 45
 • Suppose a firm places a hedge at t = 0, when:
• S0 = Rs. 45
• F0 = Rs. 42
• We don’t know S1 and F1 since they are unknown.
• The gain/loss from the hedge will be:
payoff  ( S1  S0 )  ( F1  F0 )
 ( S1  45)  ( F1  42)
 b1  3

If this were a perfect hedge then b1 = 3 and gain/loss = 0

Financial Derivatives 46
To summarize

 At expiration b = 0
 prior to expiration the basis changes randomly (random
variable).
 Uncertainty around basis is lesser than that around the prices

Financial Derivatives 47
Hedging strategies

Current status Risk Hedge

Hold the asset Asset price may fall Short

About to buy the asset Asset price may rise Long

Short sold the asset Asset price may rise Long

Financial Derivatives 48
Hedging decisions
 Choice of underlying asset:
• Choose the underlying asset that has high correlation with the asset being
hedged.
• Best possible hedge occurs when underlying asset is same as the asset being
hedged (not always possible).
 Choice of contract maturity:
• The futures with maturity closest to but after the hedge termination date
subject to the suggestion not to be in a contract in its expiration month

Financial Derivatives 49
Hedging decisions contd..
 Hedge position

 No. of contracts to trade

Financial Derivatives 50
Hedging decisions contd..

NA = spot position in qty

QF = futures contract size (# units per contract).

NF* = optimal number of futures

Financial Derivatives 51
No. of contracts

S
 Optimal # of futures N  N A
*
F
F
*
 Define N
h*  F
NA

 We now have the minimum-variance hedge ratio (MVHR):

S
h*  
F

Financial Derivatives 52
No. of contracts

S
h 
*

F
 If r = 1.00 and sF = sS, then h* = 1.00
• F and S move in perfect unison.
• Magnitude of change in S = magnitude of change in F.

Financial Derivatives 53
Example

Microsoft Excel
Worksheet

Financial Derivatives 54
Hedge effectiveness

• Hedge effectiveness is defined as the percentage of the spot price variance

that has been removed by the hedge.
• Hedging effectiveness, e, is calculated as:

e  2 (0  e  1.00)

The higher the correlation between the spot and futures price, the more
risk that is eliminated!

Financial Derivatives 55
Illustration contd….

• Hedging effectiveness would be:

e    0.652
2
 0.4225

 What can we infer?

Financial Derivatives 56
Forward Rate Agreements a.k.a FRAs
Spot interest rate
 Spot interest rate

Financial Derivatives 58
Interest rate risk

Interest rates

Existing fixed rate lenders

Existing & prospective floating rate
borrowers
Prospective fixed rate lenders
Prospective fixed rate borrowers

Financial Derivatives 59
Interest rate risk contd..

Interest rates

Existing fixed rate lenders

Existing & prospective floating rate
borrowers
Prospective fixed rate lenders
Prospective fixed rate borrowers

Financial Derivatives 60
Forward interest rate
 Forward interest rate

 Using only spot market can we lend/borrow for a forward

period???

Financial Derivatives 61
A typical FRA

is a financial contract between two parties that gives a

guaranteed future rate of interest to cover a specified sum of
money over a specified period of time in future.
Time line of the FRA

FRA
Trade date settlement date Maturity date

0 3m 6m

Forward period Loan period

Financial Derivatives 62
Creating a hedge with an FRA
 The FRA does not involve actual lending or borrowing of
money in the cash market.

Financial Derivatives 63
Terminology

3 x 6- An agreement to fix interest payments for a 3-month

period, starting 3 months from now.
 Buy FRA – has a guaranteed rate of borrowing
 Sell FRA – has a guaranteed rate of lending
 Settlement takes place at the start date of the loan

Spot rate on loan starting day

Buyer gains Increases over contract rate

Seller gains Decreases over contracted rate

Financial Derivatives 64
FRA settlement amount

 The settlement amount can be determined using the

relationship given below (by BBA):
(L-R) or(R-L) *D*A
(B*100)+(D*L)
L= spot rate on start of loan
R = contracted rate in the FRA
D = notional loan period
A = notional principle
B = day count basis(360/365)

Financial Derivatives 65
A typical FRA deal

 Western Inds. Ltd., has an expected requirement for

funds after 3 months and is planning to raise this money
thru a LIBOR linked instrument. But it is concerned that
interest rates will head higher from current levels.
 Therefore it resorts to buying a FRA from Southern Bank
Ltd. The corporate buys a 3 X 6 FRA from the Bank at
6.75% with the benchmark rate being the 3 month LIBOR

Financial Derivatives 66
Terms of the FRA
 Notional principal $ 100 mn
 FRA trade date 1st Jan. 2009
 Loan start date 1st Apr. 2009
 FRA maturity date 30th June 2009
 FRA rate 6.75%
 30/360

 Assume, 3 month LIBOR for the Corporate on fixing date (on

01/04/2009) = 7%

Financial Derivatives 67
Settlement amount

 Substitute in the earlier formula the respective nos we can find the
amt as $61,425
 The amount Western Ind will get from Southern Bank at the
beginning of the loan

(7  6.75) *100*1000*1000*90
 61,425
(360*100)  (6.75*90)

Financial Derivatives 68
Cashflows in detail

 Cash flow calculations

(a) Interest payable by Corporate
= 100 mn* 6.75% *90/360
= $ 1.6875 mn
(b) Interest payable by Bank
= 100 mn * 7% * 90/360
= $ 1.75 mn
(c) Net payable by Bank on maturity date = $0.0625 mn
(d) Discounted amounted payable
= $ 62500/(1+7%*90/360) = $61,425
Amount payable by the Bank on settlement date = $61,425

Financial Derivatives 69
How FRA fixes the rate?
 Lets assume Western Ind hedged the rate risk thru FRA
 on 1st Apr spot rate is 7%
 So Western will borrow from the cash market at 7%
 It has to pay $1.75mn on 30th June as int payment
 It has also recd. $61, 425 from the FRA counterparty as gain
from the contract that will have a future value of $62,500 by
30th June
 Now the net payments are as follows:
 Interest on $100mn @ 7% = ($1.75mn)
 FV of gains from FRA = $0.0625mn
 Net cost of borrowing= ($1.6875mn)

 The net cost of borrowing works out 6.75% on annual terms

Financial Derivatives 70
A few more things

 For the complete reference of FRA standard terms please

refer to BBA’s website

Financial Derivatives 71
Practice question
 Suppose that the price of the N X M fra is 6%. Fill up this table
showing the interest expense on its CP. (30/360)

Future Int. expense on CP P/L on FRA

relevant
int rate (%)
5
5.5
6
6.5
7

Financial Derivatives 72
Determining the forward rate
 No arbitrage conditions.

 (1 (R0,T T 365))  365

FRA0,(T t )   1 
 (1 (r0,t  t 365))  (T  t )

T = time to maturity t = time to settlement

R0,T = Spot rate from today till maturity
r0,t = Spot rate from today till settlement
T-t = time period of the loan

Microsoft Excel
Worksheet

Financial Derivatives 73
Applications of FRA
 A bank borrows 10 mn for 12 months and lends 10mn for 9
months, both at fixed rates. Discuss the interest rate risk the
bank is exposed to. How can it use a FRA to hedge this risk?
 A bank borrows 10 mn for 9 months and lends 10mn for a year,
both at fixed rates. Discuss the interest rate risk the bank is
exposed to. How can it use a FRA to hedge this risk?

Financial Derivatives 74
Uses of FRA
 Hedging
 Corporates can hedge their future loan exposures against
rising rates.
 Speculation
 Particularly in the inter-bank market
• Buy FRA if the view is that the realized future rate will be
higher than the agreed fixed rate
• Sell FRA if the view is that the realized future rate will be
lower than the agreed fixed rate

Financial Derivatives 75
Canceling a FRA
 Since it is an OTC contract exiting is difficult
 With the consent of CP
 Reverse FRA

Financial Derivatives 76
Cancellation……
 On Aug 1 an organization bought a 3 x 6 FRA on $ 250 million.
On Sep 1 the firm feels there is no need for the FRA and
decides to cancel it.

 Approach another bank and assume the opposite position for the remaining

maturity

 Mark to market the FRA and settle for the difference with the existing CP

Financial Derivatives 77
Summary and Conclusions
 Forward and Futures contracts can be used to essentially lock in the
final purchase or sale price of an asset.
 Forward contracts are between individual parties and thus rely on
the integrity of each. Futures contracts are through organized
exchanges and include margin requirements and marking to market
– thus making the risk of default minimal.
 Forwards and futures are derivatives that can be used to speculate
or to hedge. There is less cost to get into a forward or futures
contract compared to getting into a long option position; however,
because the forward and futures contracts represent commitments,
larger losses may occur from these contracts than the losses from a
long option contract.

78