MFIN6003 Derivative Securities

Lecture Note Two

HKU Business School

University of Hong Kong

Dr. Huiyan Qiu

2-1
 Outline
Introduction to forward and futures
Types of transactions
• Spot trade, forward, futures
• Forward vs. outright purchase

Futures trading: margin and marking to market

Reading: McDonald sections 2.1 and 5.4

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 Forward Contracts
Forward contract: a binding agreement (obligation) to
buy or to sell an underlying asset in the future, at a price
set today.
A forward contract specifies
• The features and quantity of the asset to be delivered
• The delivery logistics, such as time, date, and place
• The price the buyer will pay at the time of delivery

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 Forward Contracts
At time 0, two parties sign a forward contract.
• Long forward: agree to buy
• Short forward: agree to sell
At time T,

Forward price
Long Short
Forward Forward
Asset or
Spot price
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 Forward Example
Example: a 6-month forward contract on S&R index
(not paying dividend)
• Underlying asset: S&R (Special & Rich) Index
• Spot price of the underlying asset: $1,000
• Forward price: $1,020

0 T

Long forward 0 ST – $1,020

Short Forward 0 $1,020 – ST

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 Forward Example
Payoff for a contract is its value at expiration.
In six months at contract expiration:
Case 1: Spot price ST = $1,050
• Long position payoff = $1,050 – $1,020 = $30
• Short position payoff = $1,020 – $1,050 = – $30

Case 2: Spot price ST = $1,000

• Long position payoff = $1,000 – $1,020 = – $20
• Short position payoff = $1,020 – $1,000 = $20
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Payoff Diagram for Forwards

X-axis: S&R index

level 6-month later
Y-axis: payoff for 6-
month forward

6-month forward
price = $1,020

Long: y = x – 1,020
Short: y = 1,020 – x

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 Forward and Futures
As binding agreements, forward contracts are traded in
the over-the-counter market
Futures are the same as forward in principle except for
some institutional and pricing differences.
• Futures contracts are traded in the exchange market with
highly standardized structure
• Futures are highly liquid and settled daily through the
mark-to-market process
• The price difference between forward and futures is
usually sufficiently small to be ignored.

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 Hang Seng Index Futures
Hang Seng Index Futures Daily market report. Source:
www.hkex.com.hk
HSI - Hang Seng Index Futures HK$50 per index point

Business Day: 28 JUL 2023, FRIDAY

Contract Open Daily Daily Settle- Chg in Contract Contract Volume Open Chg in
Month Price High Low ment Setl High Low Interest OI
Price Price
23-Jul 19,350 19,794 19,350 19,782 110 20,122 17,846 12,551 10,624 -6,946
23-Aug 19,400 20,003 19,398 19,964 234 20,003 17,885 13,527 95,195 1,160
23-Sep 19,435 19,998 19,431 19,963 243 22,450 16,600 146 9,447 431
23-Dec 19,678 20,210 19,660 20,180 240 25,240 15,300 33 10,451 -96
Note: only the four most actively traded futures are reported in the table.
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 Payoff for Futures
Suppose that on July 28, 2023, an investor longed one
HSIF contract expiring in September 2023 at the
settlement price of 19,963.
On September 1, 2023, the settlement price is

 If the investor closes the position on September 1,

ignoring the transaction cost, the payoff to the investor is

2-10
 Outline
Introduction to forward and futures
Types of transactions
• Spot trade, forward, futures
• Forward vs. outright purchase

Futures trading: margin and marking to market

Reading: McDonald sections 2.1 and 5.4

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 Types of Transaction
1. Spot Transaction / Cash Transaction
Suppose you want to buy 1,000 bushels of corn
Suppose the current price is US$6.845 per bushel

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 Types of Transaction
2. Forward Transaction
Suppose you want to buy 1,000 bushels of corn for next
year
The price next year is unknown/uncertain
You negotiate with the farmer, fix the price and the
quantity today with the transaction to be completed one
year later.

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 Types of Transaction
3. Futures Transaction
“Same” as forward except that futures contract are
standardized and traded in the Exchange
Clearing house is the counterparty to each transaction
Futures are also marked to market

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 Types of Transactions
Comments:
• Both parties to the contract are obliged to fulfil their
promise.
• What if the corn price one year later is US$4.5 per bushel?
What if the price one year later is US$8 per bushel?
• Forward is OTC transaction. Credit risk of the counter
party is a major issue.
• Credit check, collateral, bank letter of credit
• Futures contract has clearing house as the counter party
that guarantee the contract performance.

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 Forward vs. Outright Purchase
Two alternatives to own an asset at time T. Using S&R
as an example,
• Outright purchase: Invest $1,000 in index, own the
index, and hold until time T
• Forward: Sign the forward contract, invest $1,020 at
time T and own the index.

Outright purchase – $1,000 – $0 + index

Forward – $0 – $1,020 + index

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 Forward vs. Outright Purchase
Same outcome: own the index at expiration, time T.
Why investing $1,000 now results in the same outcome
as investing $1,020 later?
• $1,000 now = $1,020 six month later
• It implies that the effective 6-month interest rate is 2%.

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 Forward vs. Outright Purchase
Investing $1,000 in risk-free bond together with long
forward position, the cash flows will be the same as for
the outright purchase.

Outright purchase – $1,000 – $0 + index

Forward – $0 – $1,020 + index

Bond – $1,000 + $1,020

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 Forward vs. Outright Purchase
Forward on asset + Risk-free bond
= Outright purchase of asset

Figure Summing
the value of the long
forward plus the
bond at each S&R
Index price gives the
line labeled “Forward
+ Bond”.

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 Additional Considerations
Type of settlement
• Cash settlement: less costly and more practical
• Physical delivery: often avoided due to
significant costs
Credit risk of the counter party
• Major issue for over-the-counter contracts
• Credit check, collateral, bank letter of credit
• Less severe for exchange-traded contracts
• Exchange guarantees transactions, requires collateral

2-20
 Outline
Introduction to forward and futures
Types of transactions
• Spot trade, forward, futures
• Forward vs. outright purchase

Futures trading: margin and marking to market

Reading: McDonald sections 2.1 and 5.4

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 Futures Contracts
Exchange-traded “forward contracts”: with specified
delivery dates, locations, procedures
Compare with forward contracts, futures
• Highly standardized structure  harder to customize
• Settled daily through the mark-to-market process  low
credit risk
• Highly liquid  easier to offset an existing position
• Typically, daily price limits  trigger a temporary halt in
trading

2-22
 Futures Prices vs. Forward Prices
Futures prices versus forward prices: different because
of institutional difference

For short-lived contracts, the difference are in most

circumstances sufficiently small to be ignored.

The difference can be significant for long-lived contracts

and/or when interest rates are highly correlated with the
price of the underlying asset

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 Futures Trading
For each futures contract, there is at least one clearing house
• Matches buy and sell orders
• Becomes counterparty after matching the trades
• Keeps track of members’ obligations and payments
• Guarantor of contract performance
• collect margin
• settle margin account daily
The clearing house reduces its risk exposure by using
margin accounts and daily settlements

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 Margin Account
Margin account has to be set up for any futures trading.
Initial margin (IM: initial amount to establish a futures
position) and maintenance margin (MM: minimum
amount that must be kept in a margin account). MM is
usually 70-80% of IM
• Excess equity above the IM can be withdrawn
• Margin call will be issued if account balance is below
MM
• Margin call must be met promptly and in full (to IM level)

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 Example: Futures on Juice
An investor enters a long futures contract on frozen orange
juice
• Contract size 15,000 pounds
• F0,T US$1.60 / lb
• IM US$6,000
• MM US$4,500

(Q1) What price change would lead to a margin call?

(Q2) Under what circumstances could US$2,000 be withdrawn

from the margin account?

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 Example (cont’d)
Suppose the next day’s future price is F1,T , then the margin
account balance is

X = 6,000 + 15,000(F1,T – F0,T)

(Q1) What price change would lead to a margin call?

X < 4,500  F1,T < 1.5

(Q2) Under what circumstances could US$2,000 be withdrawn

from the margin account?

X ≥ 8,000  F1,T ≥ 1.74

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 S&P 500 Futures
Specifications for the S&P 500 index futures contract:

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 Example: S&P 500 Futures
Consider an S&P 500 futures which will expire in 10
weeks. For simplicity, assume weekly settlement. The
futures price is 3200.
The notional value of one futures contract is $250 ×
3200 = $800,000: the amount long is agreeing to pay at
expiration per futures contract.
Take a long position in 8 futures contract. The
corresponding future investment in S&P 500
$800,000 × 8 = $6.4 million

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 Example: S&P 500 Futures
The continuously compounding annual interest rate is
2%.
Assume 10% IM. The initial margin level is then $0.64
million.
Suppose one week later, the futures price drops to
3027.99. On a mark-to-market basis, the profit / loss on
the futures position
8 × $250 × (3,027.99 – 3,200) = – $344,020
The margin balance is then
$640,000e0.02×1/52 – $344,020 = $296,226.20
2-30
 Example: S&P 500 Futures
Mark-to-market proceeds and margin balance over 10 weeks
from long position in 8 S&P 500 futures contracts.

Week Multiplier ($) Futures Price Price Change Margin Balance ($)
0 2,000 3,200.00 640,000.00
1 2,000 3,027.99 -172.01 296,226.20
2 2,000 3,067.88 39.89 376,120.16
3 2,000 3,103.23 35.35 446,964.85
4 2,000 3,148.78 45.55 538,236.79
5 2,000 3,290.32 141.54 821,523.84
6 2,000 3,106.94 -183.38 455,079.87
7 2,000 3,180.98 74.04 603,334.94
8 2,000 3,094.74 -86.24 431,087.03
9 2,000 3,107.30 12.56 456,372.87
10 2,000 3,151.65 44.35 545,248.43
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 Example: S&P 500 Futures
For S&P 500 futures contracts, the week-10 profit on the
position is obtained by subtracting from the final margin
balance the future value of the original margin investment:

If the position had been a forward rather than a futures

position, but with prices the same, the week-10 profit would
have been

Interest is earned on the mark-to-market proceeds with the

futures contract.

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End of the Notes!

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