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Forward and Futures Contracts


Chapter 23 Forward and Futures Contracts Innovative Financial Instruments Dr. A. DeMaskey An Overview of Forward and Futures Trading Forward contracts are negotiated ... – PowerPoint PPT presentation

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Title: Forward and Futures Contracts

Forward and Futures Contracts
Chapter 23
Innovative Financial Instruments
Dr. A. DeMaskey
An Overview of Forward and Futures Trading
  • Forward contracts are negotiated directly between
    two parties in the OTC markets.
  • Individually designed to meet specific needs
  • Subject to default risk
  • Futures contracts are bought through brokers on
    an exchange.
  • No direct interaction between the two parties
  • Exchange clearinghouse oversees delivery and
    settles daily gains and losses
  • Customers post initial margin account

Futures vs. Forward Contracts
Hedging With Forwards and Futures
  • Create a position that will offset the price risk
    of another holding.
  • Short hedge
  • supplements a long commodity holding with a short
    forward position
  • Long hedge
  • supplements a short commodity holding with a long
    forward position

Relationship Between Spot and Forward Prices
  • The basis is the spread between the spot and
    futures price for the same asset at the same
    point in time T
  • Bt,T St - Ft,T
  • Initial basis
  • Maturity basis
  • At maturity, the forward price converges to the
    spot price (FT,T ST)

Basis Risk
  • Profit from short hedge
  • Bt,T - B0,T (St - Ft,T) - (S0 - F0,T)
  • Terminal value of hedge equals cover basis minus
    initial basis.
  • Real exposure is correlation between future
    changes in the spot and forward contract prices
  • Basis risk is small if price movements are highly
  • Basis risk 0 for forwards
  • Basis risk gt 0 for futures

Optimal Hedge Ratio
Net profit of short hedge position
Variance of this value
Minimizing and solving for N
Valuing Forwards and Futures
The value of unwinding a forward position early
The value of a futures, which are
marked-to-market is
the possibility that forward and futures
prices for the same commodity at the same point
in time might be different.
The Cost of Carry Model
  • If you buy a commodity now for cash and store it
    until you deliver it, the price you want under a
    forward contract would have to cover
  • the cost of buying it now
  • the cost of storing it until the contract matures
  • the cost of financing the initial purchase
  • These are the cost of carry necessary to move the
    asset to the future delivery date.

The Relationship Between Spot and Forward Prices
  • Contango
  • high storage costs and no dividends
  • Premium for owning the commodity
  • convenience yield
  • results from small supply at time 0 relative to
    what is expected at time T (after the crop
  • Backwarded market
  • future is less than spot

Relationship Between Futures Price and Expected
Future Spot Price
  • Pure Expectations Hypothesis
  • F0,T E(ST)
  • Normal Backwardation
  • F0,T lt E(ST)
  • Normal Contango
  • F0,T gt E(ST)

Applications and Strategies
  • Interest Rate Forward and Futures
  • Short-term
  • Long-term
  • Equity Index Futures
  • Currency Forward and Futures

Long-Term Interest Rate Futures
  • Treasury bond and note contract mechanics
  • CBT 100,000 face value
  • T-bond gt15 year maturity
  • T-note 10 year - bond with 6.5 to 10 year
  • T-note 5 year - bond with 4.25 - 5.25 years
  • Delivery any day during month of delivery
  • Last trading day 7 days prior to the end of the
  • Quoted in 32nds
  • Yield quoted is for reference
  • Treasury bonds pay semiannual interest
  • Conversion factors for differences in deliverable

A Duration Based Approach to Hedging
Treasury Futures Application
  • A T-Bond/T-Note (NOB) Futures Spread
  • expecting a change in the shape of the yield
  • unsure which way rates will change
  • long one point on curve and short another point

Short-Term Interest Rate Futures
  • Eurodollar and Treasury bill contract mechanics
  • Chicago Mercantile Exchange (CME or Merc),
    International Monetary Market (IMM), LIFFE
  • Altering bond duration with futures contracts
  • Creating a synthetic fixed-rate funding with a
    Eurodollar strip
  • Creating a TED spread

Stock Index Futures
  • Intended to provide a hedge against movements in
    an underlying financial asset
  • Hedging an individual stock with an index
    isolates the unsystematic portion of that
    securitys risk
  • Stock index arbitrage
  • prominent in program trading

Currency Forwards and Futures
  • Currency quotations
  • Direct (American) quote in U.S. dollars
  • Indirect (European) quote in non U.S. currency
  • Reciprocals of each other
  • Interest rate parity and covered interest

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