Yanuar Dananjaya, Bsc.

, MM

Forward

Futures Market for

Financial Asset

Forward: Agreement between two parties to trade

something in a certain date with previously agreed
price
Ex: A farmer agreed to sell 10 tons of wheat to bread factory 6
months from now with price of $10,000 per ton

To reduce risk for both parties

Farmer calculated that he needs to sell wheat min at $9,000.
Less than that, he will incur loss

Bread factory calculated that it needs to buy wheat max at

$12,000. More than that, he will incur loss

Historically wheat price fluctuated between $7,000 and $13,000.

By entering a forward contract, both the farmer and the bread
factory lock the price, thus ensure desirable price for both parties

Thus eliminate price risk

But also eliminate possibility of huge gain from price movement

Yanuar Dananjaya, Bsc., MM

Forward

Futures Market for

Financial Asset

Forward contract value for buyer and seller:

Yanuar Dananjaya, Bsc., MM

Forward

Futures Market for

Financial Asset

Company value for buyer:

Yanuar Dananjaya, Bsc., MM

Forward
Motivation for forward contract:
Hedging (lindung nilai) Protect the value of an asset from change
of price

Futures Market for

Financial Asset

Speculation Gain profit from change of price no underlying

asset

Speculator is important to provide counter party for hedger

Important characteristics of forward contract:
Underlying asset
Settlement date
Future price
Long position position in contract that will buy the underlying
asset

Short position position in contract that will sell the underlying

asset

Yanuar Dananjaya, Bsc., MM

Forward

Futures Market for

Financial Asset

Will Hedging only reduce the companys value

variation, or will the value also increase?
Also increase!
Companys value depends on cash flow discounted with a certain
discount rate

Companies that are less risky can earn higher cash flow from
higher sale, lower price from supplier, lower salary, etc

Companies that are less risky have lower RRR

Problem with forward:
High counter party risk
Cannot be sold before settlement date

Yanuar Dananjaya, Bsc., MM

Future
Future is created to eliminate weakness in forward

Forward is not standardized, while future is standardized easier

Futures Market for

Financial Asset

to sell or buy

In forward, both parties exchange the physical commodities. In

future, commodities are paid with cash

In forward transaction happen only in settlement date. In futures,

transaction happen every day in marked to market basis

Yanuar Dananjaya, Bsc., MM

Future
Ex:

At 1st Dec, Mr. A engage a future contract to sell 2 tons of wheat at

Futures Market for

Financial Asset

1st March at price $1,000 per ton to Mr. B

Both party must have account in bank

At 2nd Dec, future contract for wheat at 1st March delivery is $990.
Mr. B must pay Mr. A $20.

At 3rd Dec, future contract for wheat at 1st March delivery is $1000.
Mr. A must pay Mr. B $20.

At 4th Dec, future contract for wheat at 1st March delivery is $1200.
Mr. A must pay Mr. B $400.

Etc until settlement date

Mr. B then use the proceeding money to buy wheat from market
(not necessarily from Mr. A)
Notice: price depends on market, payment deducted and credited
from bank account

Futures Market for

Financial Asset

Yanuar Dananjaya, Bsc., MM

Future

Yanuar Dananjaya, Bsc., MM

Futures Market for

Financial Asset

Future
All kind of factors can be used for underlying assets
Commodity price
Interest rate
Foreign exchange
Stock index
Stock price
Government bond
Temperature

Yanuar Dananjaya, Bsc., MM

Future
Risk on futures contract
Market risk loss due to wrong prediction of price movement. Only

Futures Market for

Financial Asset

affect speculator

Basis risk loss due to hedging fail to cover asset value entirely.
Ex: asset in cross hedging behave differently from asset to be
protected

Liquidity risk Unable to sell future contract when need cash

Credit risk the other partys account is not sufficient.

Yanuar Dananjaya, Bsc., MM

Future
Risk on futures contract (cont)
Prepayment risk underlying asset disappear before settlement
date. Ex: bond with call feature, bread factory cancel production.

Futures Market for

Financial Asset

Operational risk loss due to human error. Ex: wrong calculation of

net exposure, wrong hedging strategy