Forwards and Futures

Forwards and Futures

 Both forwards and futures are agreements to

buy or sell an asset at a future time for a
certain price.
 Future contracts are traded in organized
exchanges and contract terns are
standardized.
 Forward contracts are private agreements
between two institutions.
Future Contracts

 Futures are agreements to buy or sell an

asset at a future time for a certain price.
 A contract is usually referred to by its
delivery month.
 There is a period of time during which the
delivery can be made.
 Trading ceases some time before the
delivery period.
Future Contracts - Delivery

 The majority of the contracts do not lead to

delivery.
 The contracts are generally closed out prior
to delivery.
 Closing a position involves entering into an
opposite trade to the original one that
opened the position.
Future contracts - Closing

 For example an investor who bought july

corn futures may close the contract on june
31 by selling the same amount of contracts.
 Seemingly an investor who sold short
September coffee contract, may close its
position by buying the same amount of
contracts at August 25.
FUTURE CONTRACTS

 To write a contract:
1. Continuous demand and supply
2. The value of the underlying asset should be above a
certain treshold and its price should be competitive
and volatile.
3. The investors should need protection.
4. Investors rights should be guaranteed.
FUTURE CONTRACTS

 The contracts must specify:

1. The underlying asset and its standards
2. The contract size
3. Delivery months
4. Quotation form
5. Transaction time interval
6. İnitial and Maintenance Margins
7. Price Limits
8. Last transaction date
9. The place of delivery
10. The time of delivery
1. The Asset

 The asset mey be either a commodity or a financial

instrument.
 When the asset is a commodity the grade becomes
important.
 For some commodities a range of grade is specified
and the price depends on the grade chosen.
 For financial assets on the other hand future
contracts are generally well defined and are
unambiguous.
2. Contract Size and Maturity

 The amount of each contract should be

specified; for example wheat contracts are
written on 10tons basis
 General maturity months are march, june,
september and december.
2. Contract Size

 It spcifies the amount of the asset to be

delivered.
 If it is too large, the hedgers may fail to trade.
 If it is too small trading may be expensive
due to costs associated with each contract.
3. Delivery arrangements

 For commodities delivery place is important.

 Particularly for commodities with high transportation
cost, delivery place becomes important.
 Deliveries are assigned to warehouses. Prices are
adjusted according to the location of the party with
short position.
 The time of delivery for commodities is generally the
whole month.
 The contract specifies when the delivery will begin
and end.
Price Limits and Price Quotes

 Price quotes depend on the commodity and on

exchange.
 For example crude oil prices in New York Mercantile
exchange are quoted in usd and cents whereas treasur
bond prices are quoted as usd and 32nds of a dollar.
 In a lot of exchanges there are limits to daily movements.
 If in a day the price moves down from the previous days’
close by an amount equal to the daily price limit, the
management of the exchange ceases trading.
Price Limits

 A limit move is a move in either direction equal to the

daily price limit.
 The purpose of the limits is to prevent speculative
movements.
 A view says that limits are artificial barriers to trading
and so harmful for markets.
 Besides price limits exchanges sometimes exert
position limits; position limits are maximum number
of contracts that an investor may hold.
Convergence to spot

 As the delivery period is approached future

price converges to spot price.
 Otherwise arbitrage opportunity arises.
Convergence of Futures to Spot

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
Margins

 A margin is cash or marketable securities

deposited by an investor with his or her
broker
 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
Margins

 Initial Margin Requirement IMR: minimum amount

the investor should pay at the day of settlement.
 Maintenance margin requirement (MMR):
minimum amount equity can be before additional
funds must be put into the account.
 At the transaction date the purchaser / seller
invests initial margin and adds funds when the
investments fall below maintenance margin
requirement.
Example of a Futures Trade

 An investor takes a long position in 2

December gold futures contracts on June 5
– contract size is 100 ounces.
– futures price is US$900 per ounce.
– The value of the contract is 900$*100ounce*2 =$180,000
– Initial margin requirement is US$2,000/contract (US$4,000
in total)
– Maintenance margin is US$1,500/contract (US$3,000 in
total)
Margin Call

price investment daily profit and loss margin call margin call margin
5-Jun 900 180,000 180,000 4,000
5-Jul 897 179,400 -600 3,400
6-Jul 896 179,220 -180 3,220
9-Jul 898 179,640 420 3,640
10-Jul 897 179,420 -220 3,420
11-Jul 897 179,340 -80 3,340
12-Jul 895 179,080 -260 3,080
13-Jul 893 178,660 -420 2,660 1,340 4,000
16-Jul 894 178,720 60 2,720 4,060
17-Jul 892 178,360 -360 2,360 3,700
18-Jul 893 178,540 180 2,540 3,880
19-Jul 887 177,400 -1,140 1,400 2,740 1,260 4,000
Margins
 Many brokers allow investors earn interest on the balance of
margin account.
 Therefore they are not true costs.
 Some brokers accept treasury bills instead of cash.
 Minimum levels for initial and maintenance margin
requirements are set by the exchange.
 Brokers may require margins higher than those required by the
exchange but not lower.
 Margin requirement may depend on the objective of the trader.
 In some instances companies that use the future instruments
for hedging purposes are subject to lower margins whereas
speculators to higher ones.
Derivative Market

 The derivative market is composed of 5 main

participants:
 Stock exchange
 Clearing house
 Brokers
 Investors
 Regulatory Institutions
1. Stock Exchange

 The main function of the stock exchange is to ensure

that the transactions are completed in a trusthfull
and competitive manner.
 They are founded either as cooperatives or
independent companies.
 They may work in traditional physical environment or
may engage in electronic trading.
 VOB is a company and uses electronic trading
system.
1. Stock Exchange

 Main functions:
1. To issue price and volume data about daily transactions
2. To design the contracts
3. To determine the brokerage institutions
4. To determine initial and maintenance margins
5. To make regulations about the functioning of the market
6. To impose sanctions when required
2. Clearing House

Clearing House:
 Acts as buyer when an investor wants to sell
 Acts as seller when an investor wants to buy
 Guarantees the rights and obligations of investors
 Guarantees payment and delivery requirements
 Controls risks
 Collects and follows margins
2. Clearing House
 Clearinghouse acts as intermediary in future
transactions.
 All brokers are members of the clearinghouse. Those
that are not members do their transactions through a
member.
 The clearinghouse keeps track of all the transactions
and calculates the net position of each member.
 Each member broker keeps a margin in
clearinghouse which is called clearinghouse margin.
The margin is adjusted and renewed at the end of
each day.
Clearing

 In determining the clearinghouse margin exchanges

may use net or gross basis.
 Assume a broker has two clients; one with 20 long
contracts the other with 15 short contracts.
 If the exchange uses net basis, the clearing margin
is calculated over 5 contracts, if gross basis over 35
contracts.
 The majority of the exchanges use net basis in
calculating the margin.
3. Brokers

 Brokers act as intermediary institutions for investors who

want to make derivative transactions
 Brokers may be either clearing house member or not.
 The members may complete the clearing on behalf of
themselves or their customers.
 Non members may complete the clearing through a
member.
 Completing the clearance means to collect the margins
from customers and deposit them in the clearinghouse
account.
Brokers

 There are 3 types of brokers:

 Direct Clearing members: They fulfill the
clearing on behalf of themselves and their
customers
 Independent Clearing Members: They fulfill
the clearing of other institutions
 General Clearing members: fulfill all type of
clearing transactions
4. Investors

 Individuals taking position whether locals or clients of

FCM s may be:
1. Hedgers
2. Speculators
A. Scalpers: Watch every short term movements
and hold positions anly for a few minutes.
B. Day traders: Hold position less than one trading
day
C. Position traders: Hols positions for longer
periods.
3. Arbitrageurs
5. Regulatory Institution

 The transactions made in the stock exchange are

subject to auditing. In turkey the regulatory body is
SPK. Its main duties are:

 TO PROTECT INVESTORS
 TO AVOID PRICE SPECULATION
OTC Market

 In organized exchanges margin system has

successfully ensured the funds in future transactions.
 Credit risk however is an important feature of over
the counter markets.
 Over the counter markets has adopted some
procedures to overcome the credit risk.
 A method to overcome risk is collateralization.
OTC Market-Collateralization

 Consider two companies A and B that enteres in

an over-the-counter contract.
 Collateralization contract requires them to value
the contract every day.
 If the value of the contract increases A is
required to pay to B the difference and
viceversa.
 Interest is paid on outstanding cash balances.
Future Quotes

Name Contract Last Change Open High Low Time Links

Wheat ZWU12 (Sep '12) 881-6 5 873-4 885-4 871-0 01:35
Wheat ZWZ12 (Dec '12) 901-4 0 893-6 906-4 890-6 01:36
Wheat ZWH13 (Mar '13) 912-2 8 903-6 915-2 903-6 01:18
Corn ZCU12 (Sep '12) 812-4 -3 808-4 816-0 805-6 01:36
Corn ZCZ12 (Dec '12) 818-6 4 814-6 822-0 811-6 01:36
Corn ZCH13 (Mar '13) 818-2 4 814-4 821-0 811-4 01:34
Soybeans ZSU12 (Sep '12) 1743-6 12 1729-4 1745-2 1723-6 01:33
Soybeans ZSX12 (Nov '12) 1732-4 13 1715-4 1735-0 1710-6 01:36
Soybeans ZSF13 (Jan '13) 1724-0 18 1706-6 1726-2 1703-6 01:28
QUOTES
Future Quotes

 Highest price of the day

 Lowest price of the day
 Settlement price
 Open interest: Number of contracts
Futures for Crude Oil on Aug 4,
2009

 Crude oil prices increase with the maturity of

the contract. This is called “normal market”.
Futures for Soybeans on Aug 4,
2009

 Soybean prices decrease with the maturity of

the contract. This is called “inverted market”.
Futures for Lean Hogs on Aug 4,
2009

 Prices may show a mixture of normal and

inverted market.
Future Contracts: Delivery

 Very few contracts lead to delivery: They are

generally closed out early.
 When not closed out, delivery is required and
the party with short position (investor or seller)
makes the decision.
 Investor issues a notice of intention to deliver
to the clearinghouse.
 The exchange chooses a party with long
position to accept delivery.
Future Contracts: Delivery

 Assume at Aug 2012 A agrees to sells wheat to B at

Nov 2012.
 A is the seller (short position) and B is the buyer (long
position) of the contract.
 At Sept 2012 B sells the same amount of wheat to C
and closes its position.
 At Oct 2012 C closes its position by selling the same
amount of wheat to D.
 In this case A has to deliver to D.
 It is the job of the exchange to meet the buyer and
seller in times of delivery.
Future Contracts: Delivery

 In case of a commodity the party making

delivery is responsible of all warehouse costs.
 If the commodity is a livestock (animals) there
may costs of feeding and looking after
animals.
 In case of financial futures, delivery is made
by wire transfer.
Types of Orders

 Ordersare instructions to the brokers on how

to complete the order

– Market order: execute immediately at the best

price

– Limit order: Order to buy or sell at a specified

price or better
 E.G.: 29/12 oil future trading at $50, could place a buy limit
at 49,9 or a sell limit order at 50,25.
Types of Orders

 Stop
loss order: Becomes a market sell order
when the trigger price is encountered.
– E.G.: You own a stock future trading at $40. You
could place a stop loss at $38. The stop loss
would become a market order to sell if the price of
the stock hits $38.
 Stop
buy order: Becomes a market buy order
when the trigger price is encountered.
– E.G.: You shorted stock future trading at $40. You
could place a stop buy at $42. The stop buy would
become a market order to buy if the price of the
stock hits 42.
Types of Orders

 Discretionary order: gives the broker the

power to buy and sell for your account at the
broker's discretion.
 Time dimension on orders (other than market
orders):
– IOC: immediate or cancel
– Day: by default
– GTC: good until canceled (usually 60 days max)
Forward Contracts vs Futures Contracts

 Forward contracts are similar to future contracts

but they are traded in over the counter market.
 They are typically entered into by two financial
institutions or by a financial institution and one of
its clients.
 Usually delivery date is single and contracts are
not settled daily.
Forward Contracts vs Futures
Contracts
Forward
Private contract between two parties
Not standardized
Usually one specified delivery date
Settled at end of contract
Delivery or final settlement usual
Some credit risk
Futures
Traded on an exchange
Standardized
Range of delivery dates
Settled daily
Usually closed out prior to maturity
Virtually no credit risk
Profit from a Long Forward or
Futures Position

Profit

Price of Underlying
at Maturity
Profit from a Short Forward or
Futures Position

Profit

Price of Underlying
at Maturity
Hedging Strategy

 The aim of the hedging strategy is to

eliminate a particular risk.
 A perfect hedge is the one that completely
eliminates the risk.
 When an individual or company chooses to
use future markets for hedging risks, the
objective is to neutralize the risky position as
far as possible.
Hedging Strategy

 Assume that the company will gain $10,000

for each one cent increase of the commodity
price for the next three months and loose
$10,000 for each one cent decrease.
 If the company treasurer invests in a future
contract that leads to $10,000 loss for each
one cent increase and gain for each one cent
decrease, the position is called perfect
hedge.
Short Hedge

 A short hedge involves a short position in

futures contracts.
 It is appropriate when:
– The hedger already owns an asset and intends to
sell it in the future or
– The hedger intends to sell the asset that it will be
owned in the future.
Short Hedge

 Assume a Turkish exporter that sold usd

2,000,000 worth of commodity on account.
The payment will be effected in three
months.
 What will be TL-USD rate in 3 months?
Short Hedge

 Jan15: Assume a Turkish exporter that sold

usd 2,000,000 worth of commodity on
account. The payment will be effected in April
15.
 At jan 15 TL/$ spot rate is 5.30. April 15
future prices are quoted as 5.65TL/$.
Short Hedge
 Short hedge strategy:
1. At Jan 15 buy a 2,000,000$ sales contract
(take short position)
2. April 15: te close the position

Scenario 1 : 15 April spot TL/$ 5.55

 Short Future contract +5.65
 Close position -5.55
 Sell Usd at spot market +5.55
 Net rate +5.65
Short Hedge

Scenario 1 : 15 April spot TL/$ 5.75

Short Future contract +5.65
Close position -5.75
Sell Usd at spot market +5.75
Net rate +5.65

In each case the company is locked to

5.65 TL/$.
Long Hedge

 It involves taking a long position in a futures

contract.
 It is appropriate when the company knows it
will purchase an asset in the future and
wants to lock in price know.
Long Hedge

 Jan 15: A firm imported goods worth of

$1,000,000 and will make the payment at
April 15.
 At jan 15 TL/$ spot rate is 5.30. April 15
future prices are quoted as 5.65TL/$.
Long Hedge

 Long hedge strategy:

1. At Jan 15 buy a 1,000,000$ purchase contract
(take long position)
2. April 15: close the position

Scenario 1 : 15 April spot TL/$ 5.55

1. Long Future contract -5.65
2. Close position +5.55
3. Buy Usd at spot market -5.55
4. Net rate +5.65
Long Hedge)
Scenario 2 : 15 April spot TL/$ 5.75
Long Future contract -5.65
Close position +5.75
Buy Usd at spot market -5.75
Net rate -5.65
In each case the company is locked to 5.65 TL/$.
Advantages of Hedging

 Hedging eliminates risks.

 Retailers, manufacturers, wholesalers do not
have financial expertise.
 Through hedging they may forget about risks
and concentrate on their main activities.
Disadvantages of hedging

 There are two main disadvantages.

Price fluctuations may cause profits to
increase.
– In the crude oil example, when the spot price of crude
oil is $55 at the date of expiration of the contract the
company makes a profit of $4 per barrel.
– If the spot price at the date of expiration is $65, the
company makes a loss of $6.
– What happens if the competitor did not hedge???
Disadvantages of hedging
 There are two main disadvantages.
Hedging itself may cause price fluctuations.
– A jewellery manufacturer purchases gold and produces and
sells jewellery.
– Assume to be on the safe side the company hedged its gold
purchases.
– Jewellery prices fluctuate with gold prices.When gold prices
go up, jewellery prices also go up and vice versa.
– The company that hedged gold purchases pays a greater bill
when gold prices go down.
– And when gold prices go down its sales also decreases as
jewellery prices go down causing a loss of profits for the
company.
Disadvantages of hedging

input output
gold jewellery
company A hedged gold purchases company B did not hedge
gold pricesjewellery prices costs sales profits costs sales profits

increase increase decrease increase increase increase increase none

decrease decrease increase decrease decrease decrease decrease none
HEDGING

 LOOK TO BIG PIUCTURE AND

CALCULATE THE EFFECT ON PROFITS.

 A LOT OF TIMES TREASURERS ARE

RELUCTANT TO HEDGE…
Hedging

 Hedging is not always straightforward.

1. The asset to be hedged may not exist or may
not be the same as the asset underlying futures
contracts.
2. The hedger may not be certain of the exact date
the asset will be bought or sold.
3. The hedge may require that the futures contract
is closed out before delivery date.
 All these problems give rise to “basis risk”.
 Mathematical formula

Compound Interest = (1 + r/m)n -1

 Continuous Compounding
 What is the FV of $1,000 earning 8% with continuous
compounding, after 100 years?

Compound Interest = e rn
Where r= period interest
n= no of periods

Compound interest = e .08x100

FV = PV*e .08x100 = 2,980,957

ONLY CONTINUOUS COMPOUNDING IS USED IN CALCULATIONS IN
DERIVATIVE MARKETS.
 Futures and Forwards on Currencies
 A foreign currency is analogous to a security

 providing a dividend yield

 The continuous dividend yield is the foreign risk-free
interest rate
 It follows that if rf is the foreign risk-free interest rate

( r rf ) T
F0  S0e
Futures and Forwards on Currencies

 A foreign currency holder can earn interest on its security.

 Assume an American investor has 1000 euros at time T0.
 He needs USD at time T1.
 The investor has two choices:
1. He will invest euros at time T0 and make a forward contract for
time T1
2. He will convert euro to usd at time T0 and invest in an account
until T1
Futures and Forwards on
Currencies
1000 units of
foreign currency
at time zero

Strategy 1 Strategy 2

rf T
1000 e 1000S0 dollars
units of foreign at time zero
currency at time T

rf T
1000 F0 e 1000 S 0 e rT
dollars at time T dollars at time T
Futures and Forwards on
Currencies

 To avoid arbitrage the two strategies must give the

same payoff. So:
 1000 F0 e(rf)T = 1000 S0e(r)T

 From here we get:

( r  r f )T
F0  S 0 e
Futures and Forwards on Currencies

 Assume two years interest rates are 5% in

Australia and 7% in US. The spot rate for
USD/AUD = 0.62
 What should be 2 years forward rate?

 F0 = 0.62 e (0.07-0.05)*2 = 0.6453

Arbitrage Strategy

forward rate 0.6300 forward rate 0.6600

today today
*borrow 1,000 AUD at 5 % 2 years* *borrow 1,000 USD at 7 % 2 years*
convert to USD: rate 0.62 620,00 convert to AUD: rate 0.62 1.612,90
**invest 620 usd at 7% for 2 years - 620,00 **invest 1612.90 AUD at 5% for 2 years
- 1.612,90
forward contract to buy 1105.17 AUD ***forward contract to sell 1782.53 AUD

2 years later 2 years later

receive proceedings of investment 713,17 receive proceedings of investment 1782,53 AUD
close forward contract(1105.17*0,63) - 696,26 close forward (1782.53*0.66) 1.176,47
close loan close loan - 1.150,27

net gain 16,91 net gain 26,20

* at maturity 1105.17 AUD will be paid * at maturity 1150.27 usd will be paid
** at maturity 713.17 usd will be received ** at maturity 1782.53 AUD will be received