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Forward and Futures


Contracts
Marcela Valenzuela
2/39
Forward Contract
A Forward Contract is a contract made today for delivery of an
asset at a pre-specied time in the future at a price agreed upon
today:
The buyer of a forward contract agrees to take delivery of an
underlying asset at a future time, T, at a price agreed upon
today.
No money changes hands until time T.
The seller agrees to deliver the underlying asset at a future
time, T, at a price agreed upon today.
A forward contract, therefore, simply amounts to setting a price
today for a trade that will occur in the future.
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Forward Contract
Suppose that on February 1 you want to buy a book, go to the
bookstore but the book is sold out. The cashier tells you that he
will reorder the book for you. The cost of the book is $10.
If you agree on February 1 to pick up and pay $10 for the book
when called, you and the cashier have engaged in a forward
contract.
February 1 Date when Book Arrives
Buyer
Buyer agrees to: Buyer:
1. Pay the purchase price of $10 1. Pays purchase price of $10
2. Receive book when book arrives 2. Receives the book
Seller
Seller agrees to: Seller:
1. Give up book when book arrives 1. Gives up book
2. Accept payment of $10 when book arrives 2. Accepts payment of $10
4/39
Long and Short Positions
The buyer (long position) of a forward contract is obligated to:
take delivery of the asset at the maturity date.
pay the agreed-upon price at the maturity date.
The seller (short position) of a forward contract is obligated to:
deliver the asset at the maturity date.
accept the agreed-upon price at the maturity date.
5/39
Forward Contract
Forwards can be used for hedging:
Commodity price risk
Foreign exchange risk
Stock market risk
Interest rate risk
6/39
Hedging with Commodity Forwards
A farmer is currently growing 1 ton of wheat for harvest and
sale in September.
The farmer needs to plan his September budget now, because
of upcoming expenses.
Wheat currently sells for $100 per ton.
There is no current trend (expected increase or decrease) in
wheat prices.
Wheat prices can change unexpectedly.
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Hedging with Commodity Forwards
A cereal maker plans to purchase 1 ton of wheat in September
to make cereal.
The cereal maker would like to set its sales price for September
now (e.g. for marketing purposes).
The farmer and cereal maker can both hedge their September
cash ows by signing a forward contract.
8/39
Hedging with Commodity Forwards
Commodity forward
Cereal maker promises to purchase 1 ton of wheat from
the farmer on September 1
st
at $100.
This is called going long or buying a forward
contract.
Farmer promises to sell the same amount and price.
This is called going short or selling the forward
contract.
No money changes hands at contract signing
The delivery price is set so that the contract has a value
of zero at time 0.
9/39
Cash Settlement vs. Delivery
On September 1
st
the spot price of wheat is $110 per ton.
The cereal maker and farmer have a forward contract to trade
at $100.
Cash settlement saves transport costs:
Farmer sells his wheat for $110 to his local grainstore.
Cereal maker purchases his wheat for $110 from his local
depot.
The farmer sends the cereal maker a check for $10.
Both parties eectively traded at $100, as agreed.
10/39
Payos from Forward Contracts
The payo from a long position in a forward contract on one
unit of an asset is:
S
T
K
The payo from a short position in a forward contract on one
unit of an asset is:
K S
T
where K is the delivery price and S
T
is the spot price of the asset
at maturity of the contract.
As it costs nothing to enter into a forward contract, the payo
is also the traders total gain or loss from the contract.
11/39
Forward Prices
How forward prices are related to the spot price of the
underlying asset?
First, it is important to distinguish between investment assets
and consumption assets.
An investment asset is an asset that is held for investment
purposes, for instance stocks and bonds.
A consumption asset is an asset that is held primarily for
consumption. It is not usually held for investment. For instance
oil, pork bellies, etc.
12/39
Forward Prices
Second, it is important to understand what short selling is.
Short selling involves selling an asset that is not owned.
Suppose an investor instructs a broker to short 500 IBM shares.
The broker, then, will borrow the shares from another client.
At some stage, the investor will close out the position by
purchasing 500 IBM. These are then replaced in the account of the
client from which the shares were borrowed.
The investor takes a prot if the stock price has declined and a
loss if it has risen.
13/39
Forward Prices
Notation:
T: Time until delivery date in a forward contract (in years).
S
0
: Price of the asset underlying the forward contract today.
F
0
: Forward price today.
r : Risk-free rate of interest per annum for an investment
maturing at the delivery date (i.e., in T years).
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Forward ContractsNo Income
Forward contract written on an investment asset that provides
the holder with no income. For example: non-dividend-paying
stocks and zero-coupon bonds.
Consider a long forward contract to purchase a
non-dividend-paying stock in three months. Assume that the
current stock price is $40 and the 3-month risk-free interest rate is
5% per annum.
Suppose that the forward price is $43. This price is too high,
why? How can an arbitrageur make prot?
15/39
Forward ContractsNo Income
An arbitrageur can:
borrow $40 at the risk-free interest rate of 5% per annum.
buy one share.
short a forward contract to sell one share in 3 months.
At the end of three months, the arbitrageur:
delivers the share and receives $43.
the sum of the money required to pay o the loan is:
40e
0.05 x 3/12
= $40.5
Prot: $43 $40.5 = $2.50
16/39
Forward ContractsNo Income
If the forward price is instead $39, an arbitrageur can:
short one share.
invest the proceeds at 5% per annum for 3 months.
take a long position in a 3-month forward contract.
At the end of three months, the arbitrageur:
pays $39 (forward contract).
takes delivery of the share, and uses it to close put the short
position.
He gets from the savings: 40e
0.05 x 3/12
= $40.5
Prot: $40.5 $39 = $1.5
Under what circumstances do arbitrage opportunities do not
exist?
17/39
GeneralizationNo Income
Forward contract on an investment asset with price S
0
that
provides no income. Then:
F
0
= S
0
e
rT
If F
0
> S
0
e
rT
, arbitrageurs can buy the asset and short forward
contracts on the asset.
If F
0
< S
0
e
rT
, they can short the asset and enter into long
forward contracts on it.
In our example:
F
0
= 40e
0.05 x 3/12
= $40.5
18/39
Example
Consider a 4-month forward contract to buy a zero-coupon
bond that will mature 1 year from today. The current price of the
bond is $930. We assume that the 4-month risk-free rate of
interest (continuously compounded) is 6% per annum. What is the
forward price, F
0
?
In this case T = 4/12, r = 0.06, and S
0
= $930
F
0
is given by:
F
0
= S
0
e
rT
= 930e
0.06 x 4/12
= $948.79
This would be the delivery price in a contract negotiated
today.
19/39
Forward ContractsKnown Income
Forward contract written on an investment asset that provides
the holder with a predictable cash income.
Consider a long forward contract to purchase a coupon-bond
whose current price is $900. The forward contract matures in 9
months. The coupon payment of $40 is expected after 4 months.
We assume that the 4-month and 9-month risk-free rates are,
respectively, 3% and 4% per annum (continuously compounded).
Suppose that the forward price is $910. This price is too high,
why? How can an arbitrageur make prot?
20/39
Forward ContractsKnown Income
The coupon payment has a present value of:
PV($40) = 40e
0.034/12
= $39.6
An arbitrageur can:
borrow $900 to buy the bond. $900 comes from:
borrowing $39.6 at 3% per annum for 4 months so that
it can be repaid with the coupon payment.
borrowing $860.4 at 4% per annum for 9 months.
enter into a short forward contract.
At the end of nine months, the arbitrageur:
pays the loan: 860.4 e
0.04 x 9/12
= $886.6.
delivers the bond and receives $910 from the forward contract.
He gets: $910 $886.6 = $23.4.
21/39
Forward ContractsKnown Income
Suppose instead that the forward price is $870. This price is
too low, an arbitrageur can:
short the bond
enter into a long forward contract.
At t = 0 the arbitrageur:
receives $900 from the bond.
invest PV($40)=$39.6 to pay the coupon on the bond.
The remaining $900-$39.6=$860.4 is invested for 9 months at
4% per annum.
At the end of nine months, the arbitrageur gets:
860.4e
0.04 x 9/12
870 = $886.6 $870 = $16.6
22/39
GeneralizationKnown Income
Forward contract on an investment asset with price S
0
that
provides an income with a present value of I . Then:
F
0
= (S
0
I )e
rT
If F
0
> (S
0
I )e
rT
, arbitrageurs can buy the asset and short
forward contracts on the asset.
If F
0
< (S
0
I )e
rT
, they can short the asset and enter into
long forward contracts on it.
23/39
Exercise
Consider a 10 month forward contract on a stock when the
stock price is $50. We assume that the risk-free rate of interest
(continuously compounded) is 8% per annum for all maturities. We
also assume that dividends of $0.75 per share are expected after 3
months, 6 months, and 9 months. What is the forward price, F
0
?
24/39
Forward ContractsKnown Yield
Here we consider the situation where the asset underlying a
forward contract provides a known yield rather than a known cash
income.
Dene q as the average yield per annum on an asset during the
life of a forward contract with continuous compounding. Then:
F
0
= S
0
e
(r q)T
25/39
Example
Consider a 6-month forward contract on an asset. The asset
price is $25. The risk-free rate of interest (with continuous
compounding) is 10% per annum. The yield is 3.96% per annum.
What is the forward price F
0
?
In this case S
0
= 25, r = 0.1, T = 0.5 and q = 0.0396.
The price of the forward is given by:
F
0
= S
0
e
(r q)T
= 25e
(0.10.0396)0.5
= $25.77
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What is a Forward Price?
The Forward Price (F
t
) is the price such that the present value
of the contract payo at time t equals zero.
At the beginning of the life of the forward contract, the delivery
price, K, is set equal to the forward price F
0
.
As time passes, K stays the same (because it is part of the
denition of the contract), but the forward price changes and the
value of the contract becomes either positive or negative.
F
t
= S
t
e
(r q)(Tt)
The price of the forward today is:
F
0
= S
0
e
(r q)T
27/39
Valuing Forward Contracts
The value of a forward f contract at the time it is rst entered
into is zero.
At a later stage, it may prove to have a positive or negative
value.
Notation:
Let K be the delivery price for a contract that was negotiated
some time ago.
The delivery date is T years from today.
r is the T-year risk-free rate.
F
0
is the forward price that would be applicable is we
negotiated the contract today.
f : value of the forwad contract today.
28/39
Valuing Forward Contracts
The value of a long forward contract (f ) is given by:
f = (F
0
K)e
rT
The value of a short forward contract is given by:
(K F
0
)e
rT
At the beginning, the value of the contract is 0 since F
0
= K.
29/39
Exercise
A long forward contract on a non-dividend-paying stock was
entered into some time ago. It currently has 6 months to maturity.
The risk-free rate of interest (with continuous compounding) is
10% per annum, the stock price is $25, and the delivery price is
$24.
30/39
Valuing Forward Contracts
Value of a forward contract on an asset that provides no
income:
f = S
0
Ke
rT
Value of a forward contract on an asset that provides a known
income with present value I :
f = S
0
I Ke
rT
Value of a forward contract on an asset that provides a known
yield at rate q:
f = S
0
e
qT
Ke
rT
31/39
Future Contracts
When a standardized forward contract is traded on an exchange,
it is called a futures contract same contract, but a dierent label.
The exchange is called a futures exchange.
The distinction between futures and forward does not
apply to the contract, but to how the contract is traded.
32/39
Dierences between Forwards and Futures
Forward Futures
Private contract between two parties Traded on an exchange
Not standarized Standarized contract
Usually one specied delivery date Range of delivery dates
Settled at end of contract Settled daily
Some credit risk Virtually no credit risk
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The Mechanics of Futures Trading
When you buy or sell a futures contract, the price is xed today
but payment is not made until later.
You will, however, be asked to put up margin to demonstrate
that you have the money to honor your side of the bargain.
Margin is typically set at an amount that is larger than a usual
one-day moves in the futures price.
Futures contracts are marked to market. This means that each
day any prots or losses on the contract are calculated; you pay
the exchange any losses and receive any prots.
34/39
Margin
The futures exchange guarantees the contracts and protects
itself by settling up prots or losses each day.
The margin ensures that both parties will have sucient funds
available to mark to market.
Futures trading eliminates counterparty risk. The whole
purpose of the margining system is to eliminate the risk that a
trade who makes a prot will not be paid.
35/39
Margin
Margin rules are stated in terms of:
Initial margin (which must be posted when entering the
contract).
Maintenance margin (which is the minimum acceptable
balance in the margin account).
If the balance of the account falls below the maintenance level,
the exchange makes a margin call upon the individual, who must
then restore the account to the level of initial margin before the
start of trading the following day.
36/39
Futures Contracts - Marking to Market
Futures Marking to Market:
Buy 200 Futures at $600.
Initial Margin = $4,000 per contract.
At the end of each trading day, the margin account is
adjusted to reect the investors gain or loss.
If the futures price dropped from $600 to $597, loss of
$600(= 200 x $3). Margin account balance: $3,400.
If the futures prices dropped from $597 to $596.1, loss of
$180(= 200 x $(597 596.1)). Cumulative loss:
600 + 180 = 780. Margin account balance: $3,220.
Assume that the maintenance margin is $3,000. On June 13,
the margin in the balance account falls $340 below the
maintenance margin level margin call from the broker for an
additional $1,340.
37/39
Futures Contracts - Marking to Market
Day Futures Daily gain Cumulative Margin Account Margin
Price (loss) gain (loss) Balance call
($) ($) ($) ($) ($)
600.0 4,000
June 5 597.0 (600) (600) 3,400
June 6 596.1 (180) (780) 3,220
June 9 598.2 420 (360) 3,640
June 10 597.1 (220) (580) 3,420
June 11 596.7 (80) (660) 3,340
June 12 595.4 (260) (920) 3,080
June 13 593.3 (420) (1,340) 2,660 1,340
June 16 593.6 60 (1,280) 4,060
June 17 591.8 (360) (1,640) 3,700
June 18 592.7 180 (1,460) 3,880
June 19 587.0 (1,140) (2,600) 2,740 1,260
June 20 587.0 0 (2,600) 4,000
June 23 588.1 220 (2,380) 4,220
June 24 588.7 120 (2,260) 4,340
June 25 591.0 460 (1,800) 4,800
June 26 592.3 260 (1,540) 5,060
38/39
Futures Prices of Stock Indices
Here we consider a situation where the asset underlying a
forward contract provides a known yield rather than a known cash
income:
F
0
= S
0
e
(r q)T
39/39
Example
Consider a 3-month futures contract on the S&P500. Suppose
that the stocks underlying the index provide a dividend yield of 1%
per annum, that the current value of the index is $1,300, and that
the continuously compounded risk-free interest rate is 5% per
annum.
The futures price, F
0
, is given by:
F
0
= 1, 300e
(0.050.01) x 0.25
= $1, 317.07

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