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These notes explore forward and futures contracts, what they are and how they are used. We will learn how to price forward contracts by using arbitrage.
Typology: Exercises
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Like options, forward and futures contracts are derivative securities. Recall, a derivative security is a financial security that is a claim on another security or underlying asset.
We will examine the specifics of forwards and futures and see how they differ from options.
Derivatives can be used to speculate on price changes in attempts to gain profit or they can be used to hedge against price changes in attempts to reduce risk. In both cases, we will compare strategies using options versus using futures.
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Both forward and futures contracts lock in a price today for the purchase or sale of something in a future time period E.g., for the sale or purchase of commodities like gold, canola, oil, pork bellies, or for the sale or purchase of financial instruments such as currencies, stock indices, bonds.
Futures contracts are standardized and traded on formal exchange; forwards are negotiated between individual parties.
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Only at the maturity of the forward or futures contract will the long party pay money to the short party and the short party will provide the good to the long party.
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Since futures contracts are traded on formal exchanges, margin requirements, marking to market, and margin calls are required; forward contracts do not have these requirements.
The purpose of these requirements is to ensure neither party has an incentive to default on their contract. Thus futures contracts can safely be traded on the exchanges between parties that do not know each other.
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Typically 10% of the total value of the contract Not a down payment, but instead a security deposit to ensure the contract will be honored
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Manohar has just taken a long position in a
futures contract for 100 ounces of gold to be delivered in January. Magda has just taken a short position in the same contract. The futures price is $380 per ounce. The initial margin requirement is 10% What is Manohar’s initial margin requirement?
What is Magda’s initial margin requirement?
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They are compensated or penalized for the change in contract terms by the marking to market deposits/withdrawals to their accounts.
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To reduce the incentive to default
Discussion:
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In addition to the initial margin requirement, investors are required to have a maintenance margin requirement for their brokerage account typically half of the initial margin requirement % or 5% of the value of the futures contacts outstanding.
Marking to market may result in the brokerage account balance rising or falling. If it falls below the maintenance margin requirement, then a margin call is triggered. The investor is required to bring the account balance back to the initial margin requirement percentage.
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Consider Manohar’s initial margin requirement, the futures price increased to $385 at the end of the first day and now the futures price decreased to $350. What are the cumulative effects of marking to market? If the maintenance margin requirement is 5% of $350/ounce x 100 ounces, what will be the margin call to bring the account back to 10% of $350/ounce x 100 ounces? What does the margin call mean?
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For some business or personal reason, you either need to purchase or sell the underlying asset in the future. Go long or short in the futures contract and you effectively lock in the purchase or sale price today. The net of the marking to market and the changes in futures prices results in you paying or receiving the original futures price I.e., you have eliminated price risk.
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Spot = $380 $395 $
Spot = $320 $395 $
Spot = $500 $395 $
Spot = $440 $395 $
Net amount received at harvest (final payoff net of initial cost) given final spot prices below:
Initial Cost $0 -$
Long Put Option, E=$
Short Futures Contract @ $
Derivative Used:
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Hedging: Futures versus Options
Net Price Received for Canola using Different Hedging Strategies
$
$
$
$
$
$
$
$
$0 $100 $200 $300 $400 $ Spot Canola Price at Harvest Time
Net Amount Received
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Zhou has been doing research on the price of gold and thinks it is currently undervalued. If Zhou wants to speculate that the price will rise, what can he do? Give a strategy using futures contracts. Zhou can take a long position in gold futures; if the price rises as he expects, he will have money given to him through the marking to market process, he can then offset after he has made his expected profits. Give a strategy using options. Zhou can go long in gold call options. If gold prices rise, he can either sell his call option or exercise it.
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Spot = $320 $10 -$
Spot = $300 -$10 -$
Spot = $280 -$30 -$
Spot = $360 $50 $
Spot = $340 $30 $
Net amount received (final payoff net of initial cost) given final spot prices below:
Initial Cost $0 -$
Long Put Option, E=$
Long Futures Contract @ $
Derivative Used:
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Speculating: Futures vs. Options
Net Profit Received from Speculating in Gold
-$
-$
-$
-$
-$
$
$
$
$
$
$200$225$250$275$300$325$350$375$
Final Spot Price of Gold
Profit fromSpeculating
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Should hedging or speculating be done?
Speculating: If the market is informationally efficient, then the NPV from speculating should be 0. Hedging: Remember, expected return is related to risk. If risk is hedged away, then expected return will drop. Investors won’t pay extra for a hedged firm just because some risk is eliminated (investors can easily diversify risk on their own). However, if the corporate hedging reduces costs that investors cannot reduce through personal diversification, then hedging may add value for the shareholders. E.g., if the expected costs of financial distress are reduced due to hedging, there should be more corporate value left for shareholders.
