Futures and Forwards

Reading 31 – Future Markets

Key features of futures contracts
• Underlying assets: Available on a wide range of assets. The futures exchange stipulates the
quality of a good that will beacceptable for settling the contract.
• Contract size: the quantity of the asset that must be delivered to settle a futures contract
(e.g., one grain contract = 5,000 bushels).
• Delivery location: The exchange specifies the place where delivery will take place.
• Delivery time: Futures contracts are referred to by the month in which delivery is to take
place (e.g., a December corn contract). Some contracts are not settled by delivery but by
payment in cash, based on the difference between the futures price and the market price
at settlement.
• Price quotes: The exchange determines how the price of a contract will be quoted as well as
the minimum price fluctuation for the contract, which is referred to as the tick size.
• Price limits. The exchange sets the maximum price movement for a contract during a day.
• Position limits. The exchange sets a maximum number of contracts that a speculator may
hold to prevent speculators from having an undue influence on the market.

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Some Terminology
• Open interest: the total number of contracts outstanding
• 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 one day

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Convergence of Futures to Spot
• The spot (cash) price of a commodity or financial asset is the price for immediate delivery.
• The futures price is the price today for delivery at some future point in time (i.e., the
maturity date).
• The basis is the difference between the spot price and the futures price.
basis = spot price − futures price
• As the maturity date nears, the basis converges toward zero.
• Arbitrage will force the prices to be the same at contract expiration.

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time
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Convergence of Futures to Spot
EXAMPLE: Why the Futures Price Must Equal the Spot Price at Expiration
Suppose the current spot price of silver is $4.65. Demonstrate by arbitrage that the futures price of a
futures silver contract that expires in one minute must equal the spot price.

Answer:
• Suppose the futures price was $4.70. We could buy the silver at the spot price of $4.65, sell the
futures contract, and deliver the silver under the contract at $4.70. Our profit would be $4.70 −
$4.65 = $0.05. Because the contract matures in one minute, there is virtually no risk to this
arbitrage trade.
• Suppose instead the futures price was $4.61. Now we would buy the silver contract, take delivery
of the silver by paying $4.61, and then sell the silver at the spot price of $4.65. Our profit is $4.65
− $4.61 = $0.04. Once again, this is a riskless arbitrage trade.
• Therefore, to prevent arbitrage, the futures price at the maturity of the contract must be equal to
the spot price of $4.65.

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Margin requirements
• Margin is cash or highly liquid collateral (i.e. marketable securities) placed in an
account to ensure that any trading losses will be met.
• 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
• The maintenance margin is the minimum margin account balance required.
• An investor will receive a margin call if the margin account balance falls below the
maintenance margin.  The investor must bring the margin account back to the
initial margin amount.

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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$1250
• initial margin requirement is US$6,000/contract (US$12,000 in total)
• maintenance margin is US$4,500/contract (US$9,000 in total)

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 A Possible Outcome
• By end of day 1, the futures Day Trade Settle Daily Cumul. Margin Margin
price has dropped by $9 from Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
$1,250 to $1,241. 1 1,250.00 12,000
Loss = $1,800 (= 200x$9), the 1 1,241.00 −1,800 − 1,800 10,200
200 ounces of December gold,
2 1,238.30 −540 −2,340 9,660
which the investor contracted to
buy at $1,250, can now be ….. ….. ….. ….. ……
sold for only $1,241. 6 1,236.20 −780 −2,760 9,240
 The balance in the margin 7 1,229.90 −1,260 −4,020 7,980 4,020
account would therefore be 8 1,230.80 180 −3,840 12,180
reduced by $1,800 to $10,200.
….. ….. ….. ….. ……
• On Day 7, the balance in the
margin account falls $1,020 below 16 1,226.90 780 −4,620 15,180
the maintenance margin level
 margin call

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Margin Cash Flows When Futures Price Increases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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Margin Cash Flows When Futures Price Decreases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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Future markets
• The exchange guarantees that traders in the futures and over-the-counter (OTC)
markets will honor their obligations
• splitting each trade once it is made and acting as the opposite side of each position.
• The exchange acts as the buyer to every seller and the seller to every buyer.
• By doing this, the exchange allows either side of the trade to reverse positions at a future
date without having to contact the other side of the initial trade.
• This allows traders to enter the market knowing that they will be able to reverse their
position.
• Traders are also freed from having to worry about the counterparty defaulting
since the counterparty is now the exchange.
Future market quotes

• Each gold futures contract represents 100 ounces and is priced in U.S. dollars per ounce.
• The CME Group website (www.cmegroup.com)
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 maturity

Example: Closing a Futures Position

You have entered a long position in 30 December S&P 250 contracts, in
August. Come September, you decide that you want to close your position
before the contract expires. To accomplish this, you must short, or sell the 30
December S&P 250 contract. The clearing house sees your position as flat
because you are now long and short the same amount and type of contract.

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Types of trading orders
• Market orders: orders to buy or sell at the best price available.
• The key problem is that the transaction price may be significantly higher or lower than
planned.
• Discretionary order: a market order where the broker has the option to delay
transaction in search of a better price.
• Limit order: orders to buy or sell away from the current market price.
• A limit buy order is placed below the current price.
• A limit sell order is placed above the current price.
• Stop-loss order: used to prevent losses or to protect profits
• Stop-loss sell order: if the price falls to a certain price, the broker will sell the asset.
• Stop-loss buy order: usually combined with a short sale to limit losses.
Forward Contracts vs Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

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Herging strategies using
futures
Reading 32
Short Hedge
• A short hedge occurs when the hedger shorts (sells) a futures contract to
hedge against a price decrease in the existing long position.
• When the price of the hedged asset decreases, the short futures position realizes a
positive return, offsetting the decline in asset value
• A short hedge is appropriate when you own an asset and expect to sell it in the future, or
you do not currently own the asset but will purchase it in the future, and expect prices to
decline
• Example:
• A short hedge could be used by a farmer who owns some hogs and knows that they will
be ready for sale at the local market in two months.
• A US exporter who knows that he or she will receive euros in 3 months. The exporter will
realize a gain if the euro increases in value relative to the US dollar and will sustain a loss
if the euro decreases in value relative to the US dollar. A short futures position leads to a
loss if the euro increases in value and a gain if it decreases in value. It has the effect of
offsetting the exporter’s risk
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Example of short hedge
• Assume that it is May 15 today and that an oil producer has just negotiated a contract to
sell 1 million barrels of crude oil. It has been agreed that the price that will apply in the
contract is the market price on August 15. The oil producer is therefore in the position
where it will gain $10,000 for each 1 cent increase in the price of oil over the next 3
months and lose $10,000 for each 1 cent decrease in the price during this period.
• Suppose that on May 15 the spot price is $80 per barrel and the crude oil futures price
for August delivery is $79 per barrel. Because each futures contract is for the delivery of
1,000 barrels, the company can hedge its exposure by shorting (i.e., selling) 1,000 futures
contracts. If the oil producer closes out its position on August 15, the effect of the
strategy should be to lock in a price close to $79 per barrel.
Example of short hedge
• Suppose that the spot price on August 15 proves to be $75 per barrel. The company
realizes $75 million for the oil under its sales contract. Because August is the delivery
month for the futures contract, the futures price on August 15 should be very close to
the spot price of $75 on that date. The company therefore gains approximately $79 - $75
= $4 per barrel, or $4 million in total from the short futures position. The total amount
realized from both the futures position and the sales contract is therefore approximately
$79 per barrel, or $79 million in total.
• For an alternative outcome, suppose that the price of oil on August 15 proves to be $85
per barrel. The company realizes $85 per barrel for the oil and loses approximately $85 -
$79 = $6 per barrel on the short futures position. Again, the total amount realized is
approximately $79 million. It is easy to see that in all cases the company ends up with
approximately $79 million.
Long Hedge
• A long hedge occurs when the hedger buys a futures contract to hedge against
an increase in the value of the asset that underlies a short position.
• An increase in the value of the shorted asset will result in a loss to the short seller  The
long hedge offsets the loss in the short position with a gain from the long futures position
• Appropriate when you own an asset and expect to sell it in the future, or when you does not
currently own an asset but expect to purchase it in the future, and expect prices to rise.

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Example of long hedge
• Suppose that it is now January 15. A copper fabricator knows it will require
100,000 pounds of copper on May 15 to meet a certain contract. The spot price
of copper is 340 cents per pound, and the futures price for May delivery is 320
cents per pound. The fabricator can hedge its position by taking a long position in
four futures contracts offered by the COMEX division of the CME Group and
closing its position on May 15.
• Each contract is for the delivery of 25,000 pounds of copper. The strategy has the
effect of locking in the price of the required copper at close to 320 cents per
pound.
Example of long hedge
• Suppose that the spot price of copper on May 15 proves to be 325 cents per pound.
Because May is the delivery month for the futures contract, this should be very close
to the futures price. The fabricator therefore gains approximately
100,000 x ($3.25 – $3.20) = $5,000
on the futures contracts. It pays 100,000 x $3:25 = $325,000 for the copper, making the
net cost approximately $325,000 – $5,000 = $320,000.
• For an alternative outcome, suppose that the spot price is 305 cents per pound on
May 15. The fabricator then loses approximately
100,000 x ($3.20 – $3.05) = $15,000
on the futures contract and pays 100,000 x $3.05 = $305,000 for the copper. Again, the
net cost is approximately $320,000, or 320 cents per pound.
Advantages and disadvantages of hedging
(+) The objective of hedging with futures contracts is to reduce or eliminate the
price risk of an asset or a portfolio
(-) Despite the outcome being more certain with hedging, basis risk still exists
(-) Hedging can lead to less profitability if the asset being hedged ends up
increasing in value
(-) Shareholders can more easily hedge risk on their own by diversifying their
investments in terms of industry and/or geography
(-) If industry prices adjust to the changes, hedging could lose money and the
hedge is unnecessary.
Basis Risk
• Basis = spot price of asset being hedged – futures price of contract used in hedge
• Basis risk arises because of the uncertainty about the basis when the hedge is
closed out
• Reasons :
(1) the asset in the existing position is often not the same as that underlying the
futures (e.g., hedging a corporate bond portfolio with a futures contract on a
U.S. Treasury bond)
(2) the hedging horizon may not match perfectly with the maturity of the futures
contract.

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Long Hedge for Purchase of an Asset

• Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is purchased
S2 : Asset price at time of purchase
b2 : Basis at time of purchase

Cost of asset S2
Gain on Futures F2 −F1
Net amount paid S2 − (F2 −F1) =F1 + b2

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Short Hedge for Sale of an Asset

• Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is sold
S2 : Asset price at time of sale
b2 : Basis at time of sale
Price of asset S2
Gain on Futures F1 −F2
Net amount received S2 + (F1 −F2) =F1 + b2

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Optimal Hedge Ratio
• We can account for an imperfect relationship between the spot and futures positions by calculating
an optimal hedge ratio that incorporates the degree of correlation between the rates.
• A hedge ratio is the ratio of the size of the futures position relative to the spot position. The optimal
hedge ratio, which minimizes the variance of the combined hedge position, is defined as follows:
S
HR   S , F
where
F
sS is the standard deviation of DS, the change in the spot price during the hedging period,
sF is the standard deviation of DF, the change in the futures price during the hedging period
rSF is the coefficient of correlation between DS and DF.
• This is also the beta of spot prices with respect to futures contract prices:

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• EXAMPLE: Minimum Variance Hedge Ratio
Suppose a currency trader computed the correlation between the spot and futures
to be 0.925, the annual standard deviation of the spot price to be $0.10, and the
annual standard deviation of the futures price to be $0.125.
Compute the hedge ratio.
• Answer:

The ratio of the size of the futures to the spot should be 0.74.
Example
• Airline will purchase 2 million gallons of jet fuel in one month and
hedges using heating oil futures
• From historical data sF =0.0313, sS =0.0263, and r= 0.928

0.0263
HR  0.928   0.7777
0.0313

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Hedging With Stock Index Futures
• A common hedging application is the hedging of equity portfolios using futures
contracts on stock indices (index futures).
• To hedge the risk in a portfolio, the number of contracts that should be
shorted is:

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• EXAMPLE: Hedging With Stock Index Futures
You are a portfolio manager with a $20 million growth portfolio that has a beta of
1.4, relative to the S&P 500. The S&P 500 futures are trading at 1,150, and the
multiplier is 250. You would like to hedge your exposure to market risk over the
next few months. Identify whether a long or short hedge is appropriate, and
determine the number of S&P 500 contracts you need to implement the hedge.
Answer:
You are long the S&P 500, so you should construct a short hedge and sell the
futures contract. The number of contracts to sell is equal to:

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Adjusting the portfolio beta
• Hedging an existing equity portfolio with index futures is an attempt to reduce the
systematic risk of the portfolio  reduction of portfolio beta

• The appropriate number of contracts:

β be our portfolio beta, β* be our target beta after we implement the strategy with
index futures, P be our portfolio value, and A be the value of the underlying asset (i.e.,
the stock index futures contract).
• Negative values indicate selling futures (decreasing systematic risk), and positive
values indicate buying futures contracts (increasing systematic risk).
EXAMPLE: Adjusting Portfolio Beta
Suppose we have a well-diversified $100 million equity portfolio. The portfolio beta relative
to the S&P 500 is 1.2. The current value of the 3-month S&P 500 Index is 1,080. The portfolio
manager wants to completely hedge the systematic risk of the portfolio over the next three
months using S&P 500 Index futures. Demonstrate how to adjust the portfolio’s beta.
Answer:
In this instance, our target beta, β*, is 0, because a complete hedge is desired.

The negative sign tells us we need to sell 444 contracts.

Why Hedge Equity Returns
• May want to be out of the market for a while. Hedging avoids the costs of selling
and repurchasing the portfolio
• Suppose stocks in your portfolio have an average beta of 1.0, but you feel they
have been chosen well and will outperform the market in both good and bad
times. Hedging ensures that the return you earn is the risk-free return plus the
excess return of your portfolio over the market.

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Liquidity Issues
• In any hedging situation there is a danger that losses will be realized on
the hedge while the gains on the underlying exposure are unrealized
• This can create liquidity problems
• One example is Metallgesellschaft which sold long term fixed-price
contracts on heating oil and gasoline and hedged using stack and roll
• The price of oil fell.....

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Pricing Financial Forwards and Futures
Reading 34
Consumption vs Investment Assets
• Investment assets are assets held by significant numbers of people
purely for investment purposes (Examples: gold, silver)
• Consumption assets are assets held primarily for consumption
(Examples: copper, oil)

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Short Selling
• Short selling involves selling securities you do not own, and it is possible with
some investment assets.
• Your broker borrows the securities from another client and sells them in the
market in the usual way
• At some stage you must buy the securities so they can be replaced in the account
of the client
• You must pay dividends and other benefits the owner of the securities receives
• There may be a small fee for borrowing the securities

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Short Selling
• In terms of motivations to sell securities short, the seller thinks the current price
is too high and that it will fall in the future, so the short seller hopes to sell high
and then buy low.

• Example: Ignoring all fees, if a short sale is made at $30 per share and the price
falls to $20 per share, the short seller can buy shares at $20 to replace the shares
borrowed and keep $10 per share as profit.
• EXAMPLE: Net Profit of a Short Sale of a Dividend-Paying Stock
Assume that a trader sold short XYZ stock in March by borrowing 200 shares and selling them for
$50/share. In April, XYZ stock paid a dividend of $2/share. Calculate the net profit from the short
sale assuming the trader bought back the shares in June for $40/share to replace the borrowed
shares and close out his short position.
Answer:
• The cash flows from the short sale on XYZ stock are as follows:
March: borrow 200 shares and sell them for $50/share +$10,000
April: short seller dividend payment to lender of $2/share −$400
June: buy back shares for $40/share to close short position −$8,000
Total net profit = +$1,600
Notation for Valuing Futures and Forward
Contracts
S: Spot price today

F: Futures or forward price today

T: Time until delivery date (in years)

r: annually compounded risk-free interest rate

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Forward Price With No Income or Yield

• The right-hand side of Equation 1 is the cost of borrowing funds to buy the
underlying asset and carrying it forward to time T
• If F > S × (1 + r)T, arbitrageurs will profit by selling the forward and buying the
asset with borrowed funds.
• If F < S × (1 + r)T, arbitrageurs will profit by selling the asset, lending out the
proceeds, and buying the forward. Hence, the equality in Equation 1 must hold.
Example
• EXAMPLE: Computing a Forward Price With No Interim Cash Flows
Suppose we have an asset currently priced at $1,000. The current
annually compounded risk-free rate is 4%. Compute the price of a six-
month forward contract on the asset.
Answer:
• F = $1,000 × 1.040.5 = $1,019.80
Forward Price With Income or Yield
• If the underlying pays a known amount of cash over the life of the forward
contract. Because the owner of the forward contract does not receive any of the
cash flows from the underlying asset between contract origination and delivery,
the present value of those cash flows must be deducted from the spot price
when calculating the forward price.
Example
• Forward Price When Underlying Asset Has a Cash Flow
Compute the price of a six-month forward on a coupon bond worth $1,000 that
pays a 5% coupon semiannually. A coupon is to be paid in three months. Assume
the annual risk-free rate is 4%.
Answer:
The income in this case is computed as:
I = 25 / 1.0250.25 = $24.84615
Using Equation 2:
F = ($1,000 − $24.84615) × (1 + 0.04)0.5 = $994.47
The Effect of a Known Dividend
• When the underlying asset for a forward contract pays a dividend, we assume that the
dividend is paid annually.
• Letting q represent the annually compounded dividend yield paid by the underlying
asset, Equation 1 becomes:

• EXAMPLE: Forward Price When the Underlying Asset Pays a Dividend

Compute the price of a six-month forward contract for which the underlying asset is a stock
index with a value of 1,000 and a continuous dividend yield of 1%. Assume the risk-free
rate is 4%.
Answer: F = 1,000 × (1.04 / 1.01)0.5 = 1,014.74
Value of a Forward Contract
• Because the forward price at every moment in time is computed to prevent
arbitrage, the value at inception of the contract must be zero. The forward
contract can take on a non-zero value only after the contract is entered into and
the obligation to buy or sell has been made
• If we denote the obligated delivery price after inception as K, then the value of
the long contract on an asset with no cash flows is computed as:
S − [K/(1 + r)T]
with cash flows (with present value I):
S − I − [K/(1 + r)T];
and with an annual dividend yield of q:
[S/(1 + q)T] − [K/(1 + r)T]
Example
• Value of a Stock Index Forward Contract
Using the stock index forward in the previous example, compute the value of a long
position if the index increases to 1,050 immediately after the contract is purchased.
Answer:
In this case, K = 1,014.74 and S = 1,050, so the value is:
(1,050 / 1.010.5) − (1,014.74 / 1.040.5) = 1,044.79 − 995.03 = 49.76
Forward Prices vs. Futures Prices
• The daily marking to market requirement on futures contracts and the unpredictable
changes in interest rates lead to price differences between futures and forwards.
• Assume asset prices are positively correlated to interest rates. A gain from an asset
price increase will be recognized immediately (due to daily settlement) and can be
reinvested at a high rate of interest. That makes a long futures contract a bit more
desirable than a long forward contract, so the former will be priced slightly higher.
• The opposite would hold true if asset prices are negatively correlated to interest rates
—the forward would be priced slightly higher in that case.
• Overall, the price differences are usually very small and can often be ignored  Use
Equation 1-3 for valuing both
• A futures contract may recognize an immediate profit but the forward contract would
only be able to recognize the present value of that profit.
Currency Futures
• Interest rate parity (IRP) states that the forward exchange rate, F [using the quote
format of XXXYYY (e.g., EURUSD)], must be related to the spot exchange rate, S,
and to the interest rate differential between the domestic (currency YYY) and the
foreign (currency XXX) country, rYYY − rXXX.
Example
• Calculate Forward Foreign Exchange Rate
Suppose we wish to compute the forward foreign exchange rate of a 10-month
futures contract on the Mexican peso. Each contract controls 500,000 pesos and is
quoted in terms of MXNUSD. Assume that the annually compounded risk-free rate
in Mexico is 14%, the annually compounded annual risk-free rate in the United
States is 2%, and the current exchange rate is MXNUSD 0.12.
Answer:
Applying Equation 4:
F = 0.12 × (1.02 / 1.14)10/12 = $0.10938 /peso
Stock Index Futures
• Stock index futures are valued similarly to forward contracts that pay dividends.
• If the average dividend yield for the contract term, q, is annually compounded, the
futures price of the stock index will be computed using Equation 3.
• With stock index futures, arbitrage opportunities will be present if:
F > S × [(1 + r) / (1 + q)]T
or F < S × [(1 + r) / (1 + q)]T
• If the futures price is greater than the theoretical value, an arbitrage profit is generated
by shorting the futures contracts and going long stocks underlying the index at the spot
price. (typically performed by pension funds that hold a portfolio of index stocks)
• If the futures price is lower than the theoretical value, an arbitrage profit is generated by
shorting stocks underlying the index and going long the futures contracts. (typically
performed by corporations or banks that hold shorter-term investments)