Forward and Futures Contracts

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Forward and Futures Contracts

• Definitions and examples

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Definition

• Future Contracts call for the delivery of a
  given quantity of currency at a given date in the
  future, at a predetermined exchange rate.
• Forward Contracts call for the delivery of a
  given quantity of currency at a given date in the
  future, at a predetermined exchange rate.

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A comparison
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Marking-to-market

• Daily settlement of the margin account

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Exemplification

• You need Swiss francs in one week, but are afraid
  the franc will appreciate against the dollar.
• On Friday, you buy one futures contract on the
  Swiss franc (SFR 125,000) at US 0.75, maturing
  next Thursday.
• You hold the contract until maturity, and take
  delivery.

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Marking to market taking delivery
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Analysis

• Your margin account
• 625-1,500-1,6252,625750 875
• You paid 94,625 for the SFRs on the spot
• You received a net 875 on margin
• The SFRs cost only (94,625-875) 93,750,
  which amounts to 0.75/SFR, the rate you locked
  in at the beginning.

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Do you really need to take delivery?

• What if you took the offsetting position at
  maturity?

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Remark

• Due to marking-to-market, it makes no difference
  from a cash flow point of view whether you take
  delivery or take the offsetting position

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Profit from a futures/forward contract

• Long position Spot price - Settlement price
• Short position Settlement price - Spot price

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Forward/futures prices and expected spot prices

• Forward/futures prices are quoted by financial
  institutions
• Expected future spot prices cannot be directly
  observed

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Forward/futures prices and expected spot prices

• If, on average, hedgers go short and speculators
  go long
• f lt E(S)
• If, on average, hedgers go long and speculators
  go short
• f gt E(S)

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Relationship between spot and forward prices for
foreign exchange

• Assume two-year rates in the US and Canada are 7
  and 5 respectively. The spot rate is USD 0.62.
  The two-year forward rate USD 0.63.

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Arbitrage portfolio for an asset providing a
known yield/return
Arbitrage profit USD 16.6
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Implication
Eventually, investors would drive down the
forward price and bid up the spot price of the
US
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Relationship between spot and forward/futures
prices for an investment asset providing a known
yield/return

• F0 S0e(r-q)T
• Where q is the known yield/return provided by the
  investment asset
• q is the interest rate on the foreign currency.

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Summary

• Forwards and futures are very similar
• Futures are standardized for trading on organized
  exchanges
• Futures are subject to marking-to-market.