Futures and Forwards

Lecture 2
2-2
Topics
Mechanics of Futures Markets (Chapter 2)
Determination of Forward and Futures
Prices (Chapter 5)
2-3
What are Forwards and Futures?
Both are agreements to deliver (or take delivery of) a
specified asset on a future date for a specified price
(delivery price).
Buying a futures or forwards is also called taking a
long position.
Selling futures or forwards is also called taking a
short position .
2-4
Spot Market vs. Forward/Future Market
Stock Bond Gold
Time = t HSBC 1-year Treasury
t=0 (today) HKD 80.00 USD 105.10 USD 1304
t=1 week HKD 82.00 USD 105.06 USD 1310
t=2 weeks HKD 84.00 USD 105.03 USD 1314
t=3 weeks HKD 83.00 USD 104.90 USD 1308
t=4 weeks HKD 81.00 USD 104.95 USD 1303
t=5 weeks HKD 85.00 USD 104.85 USD 1315
t=6 weeks HKD 87.00 USD 104.80 USD 1325
2- 5
Spot Contract
I am buying
2000 shares of
HSBC at
HKD 82 / share
I am selling
2000 shares of
HSBC at
HKD 82 / share
BROKER
BROKER
STOCK
EXCHANGE
Sell order
Buy order
(two working days later)
S
E
T
T
L
E
M
E
N
T

BROKER
BROKER
2000
Shares
HKD 164000 HKD 164000
2000
Shares
Confirmation
Confirmation
PAYMENT ALMOST IMMEDIATELY
(ON THE SPOT)
T
O
D
A
Y

T
+
2

2- 6
I am buying forward
2000 shares of
HSBC with
settlement on
21 FEB 2014 at
HKD 85 / share
I am selling forward
2000 shares of
HSBC with
settlement on
21 FEB 2014 at
HKD 85 / share
Sell order
Buy order
T
O
D
A
Y

S
E
T
T
L
E
M
E
N
T

2
2

F
E
B

2
0
1
4

2000
Shares
HKD 170000
HKD 170000
2000
Shares
Forward Contract
NO PAYMENT !!!!
PAYMENT !!!!
7
Futures Contract
I am buying
5 futures (FEB
21, 2014) of
HSBC at HKD
85 per share
I am selling
5 futures (FEB
21, 2014) of
HSBC at HKD
85 per share
BROKER
BROKER

FUTURES

EXCHANGE



Sell order
Buy order
T
O
D
A
Y

BROKER BROKER
Buy Order (5 futures
FEB of HSBC)
Initial Margin
Deposit
Initial Margin
Deposit

Marking to Market Marking to Market
Deposit Returned
Deposit Returned
Sell Order (5 futures
FEB of HSBC)
NO PAYMENT !!!!
NO PAYMENT !!!!
PAYMENTS
C
L
O
S
I
N
G


F
E
B

2
5

2
0
1
4

2- 8
Forward Contracts vs. Futures Contracts
Private contract between 2 parties Exchange traded
Not standardized contract
Standardized contract
Usually 1 specified delivery date Range of delivery dates
Settled at maturity, some credit risk Settled daily, no credit risk
Delivery or final cash settlement
usually occurs

Contract usually closed out
prior to maturity
FORWARDS FUTURES
2-9
Where Can We Buy Forward/Futures?
Forwards?
Over-the-counter (OTC)
A computer- and telephone-linked network of dealers at financial
institutions, corporations, and fund managers
Contracts can be non-standard and there is some small amount of
credit risk.

Futures?
Exchange traded
Traditionally exchanges have used the open-outcry system, but
increasingly they are switching to electronic trading.
Contracts are standard and there is virtually no credit risk.

2-10
Where Are They Traded?
The Big Exchanges

CBOT (Chicago)
LIFFE (UK)
Deutsche Terminboerse (Frankfurt)
Hong Kong Futures Exchange

But many more . (see back of the book)
2-11
2-12
2-13
Forward Price
The forward price for a contract is the delivery price
that would be applicable to the contract if it were
negotiated today (This makes the contract worth
exactly zero).

The forward price may be different for contracts of
different maturities.
2-14
Notations
S
t
: Spot price at time t
F
t
: Futures or forward price at time t
T: Time until delivery date
r: Risk-free interest rate for maturity T
2- 15
Buy 1 HSBC Share 6 Weeks Forward
Time=t S
t
F
t

t = 0 (today) 73.00 73.71
t=1 week 74.00
t=2 weeks 76.00
t=3 weeks 73.00
t=4 weeks 71.00
t=5 weeks 75.00
t=6 weeks =T 77.00
Payoff/Payoff
S
T
-F
0
= 3.29
We agreed at t (time)=0 to buy 1 HSBC share at t=6 for HKD 73.71.
To fulfill our obligation we have to buy HSBC share from our counterparty at HKD
73.71. At the same time we can sell HSBC stock at HKD77 in the spot market.
2- 16
Sell 1 HSBC Share 6 Weeks Forward
We agreed at t (time)=0 to sell 1 HSBC share at t=6 for HKD 73.71.
We can buy the HSBC share at HKD 77 in the market. We have to sell it then to
fulfill our obligation from the forward contract.
Payoff/Payoff
F
0
-S
T
= -3.29
Time=t S
t
F
t

t = 0 (today) 73.00 73.71
t=1 week 74.00
t=2 weeks 76.00
t=3 weeks 73.00
t=4 weeks 71.00
t=5 weeks 75.00
t=6 weeks =T 77.00
2-17
Forward Prices
S
0
F
0

Time = t HSBC
t = 0 (today) 73.00 73.71 F
06

t=1 week 74.00 74.60 F
16
t=2 weeks 76.00 76.49 F
26
t=3 weeks 73.00 73.36 F
36
t=4 weeks 71.00 71.23 F
46
t=5 weeks 75.00 75.12 F
56
t=6 weeks=T 77.00 77.00 F
66
= S
T
2-18
Futures Contracts
Available on a wide range of underlying assets
Exchange traded
Specifications need to be defined:
What can be delivered; (the quality of the underlying asset)
Where it can be delivered;
When it can be delivered.
For many futures contracts, delivery period is the whole month
The delivery months vary from contract to contract and are
chosen by the exchange to meet the needs of market participants.
Example: corn futures traded on CBOT have delivery months of
March, May, July , September and December.
Settled daily
2-19
Buy 1 HSBC futures, settlement date is 6
weeks later
S
t
F
t

Time = t HSBC
t = 0 (today) 73.00 73.71
t=1 week 74.00 74.60
t=2 weeks 76.00 76.49
t=3 weeks 73.00 73.36
t=4 weeks 71.00 71.23
t=5 weeks 75.00 75.12
t=6 weeks=T 77.00 77.00
TOTAL
Payoff
0
0.89

1.89

-3.13

-2.12

3.89

1.88

3.29
2-20
Sell 1 HSBC futures, settlement date is 6
weeks later
S
t
F
t
Payoff
Time = t HSBC
t = 0 (today) 73.00 73.71 0
t=1 week 74.00 74.60 -0.89

t=2 weeks 76.00 76.49 -1.89

t=3 weeks 73.00 73.36 +3.13

t=4 weeks 71.00 71.23 +2.12

t=5 weeks 75.00 75.12 -3.89

t=6 weeks=T 77.00 77.00 -1.88

TOTAL -3.29
2-21
Convergence of Futures to Spot
Suppose that the futures price is above the spot price
during the delivery period, traders then have a clear
arbitrage opportunity:
Short a futures contract
Buy the asset
Make delivery
As traders exploit this arbitrage opportunity, the
futures price will fall
Suppose the futures price is below the spot price during
the delivery period
Buy a futures contract, short sell the underlying asset, and
then wait for delivery to be made
2-22
Convergence of Futures to Spot

(a)
Time
Futures
Price
Spot Price
Time
(b)
Futures
Price
Spot Price
2-23
Margins
A margin is cash or marketable securities deposited by
an investor with his or her broker.
The balance in the margin account is adjusted to reflect
daily settlement.
Margins minimize the possibility of a loss through a
default on a contract.
2-24
Example : Margin Requirements for
HSBC Holdings

HSBC Futures (Current price is 70HK$/per share):
400 shares / lot
Initial Margin / lot (30%) HKD 8400
Maintenance Margin / lot (20%) HKD 5600
2-25
Example of a Futures Trade
An investor takes a long position (mature in Dec. 2013)
2 gold futures contracts on June 5 2013
contract size is 100 oz.
futures price is US$1600 per ounce.
margin requirement is US$2,000/contract (US$4,000 in total)
maintenance margin is US$1,500/contract (US$3,000 in total)
2- 26
A Possible Outcome

Daily Cumulative Margin
Futures Gain Gain Account Margin
Price (Loss) (Loss) Balance Call
Day (US$) (US$) (US$) (US$) (US$)
1600.00 4,000
5-Jun 1597.00 (600) (600) 3,400 0
. . . . . .
. . . . . .
. . . . . .
13-Jun 1593.30 (420) (1,340) 2,660 1,340
. . . . . .
. . . . .
. . . . . .
19-Jun 1587.00 (1,140) (2,600) 2,740 1,260
. . . . . .
. . . . . .
. . . . . .
26-Jun 1592.30 260 (1,540) 5,060 0
+
=
4,000
3,000
+
=
4,000
<
2-27
Other Key Points About Futures
They are settled daily

Closing out a futures position involves entering into
an offsetting trade

Most contracts are closed out before maturity
2-28
Delivery
If a contract is not closed out before maturity, its
usually settled by delivering the assets underlying the
contract. When there are alternatives about what is
delivered, where it is delivered, and when it is
delivered, the party with the SHORT position chooses.

A few contracts (for example, those on stock indices
and Eurodollars) are settled in cash.
2-29
Some Terminology
Open interest: the total number of contracts
outstanding
equal to number of long positions or number of short
positions

Settlement price: the price just before the final bell
each day
used for the daily settlement process

Volume of trading: the number of trades in 1 day
2-30
Questions
When a new trade is completed, what are the possible
effects on the open interest?

Can the volume of trading in a day be greater than the
open interest?
Chapter 5: Determination of
Forward and Futures Prices
2-31
Consumption vs. Investment Assets
Investment assets are assets held by significant
numbers of people purely for investment purposes
(Examples: gold, silver)

Consumption assets are assets held primarily for
consumption (Examples: copper, oil)
2-32
Short Selling
Short selling involves selling securities you do not
own
Your broker borrows the securities from another
client and sells them in the market in the usual way
At some stage you must buy the securities back so
they can be replaced in the account of the client
You must pay dividends and other benefits the
owner of the securities receives

2-33
1. An Arbitrage Opportunity?
Suppose that:
The spot price of a non-dividend paying stock is $40
The 3-month forward price is $43
The 3-month US$ interest rate is 5% per annum

Is there an arbitrage opportunity?
2-34
2. Another Arbitrage Opportunity?
Suppose that:
The spot price of non-dividend-paying stock is $43
The 3-month forward price is US$39
The 1-year US$ interest rate is 5% per annum

Is there an arbitrage opportunity?
2-35
The Forward Price
If the spot price of an investment asset is S
0

and the futures price for a contract deliverable
in T years is F
0
, then
F
0
= S
0
e
rT


where r is the 1-year risk-free rate of interest.
In our examples, S
0
=40, T=0.25, and r=0.05
so that
F
0
= 40e
0.050.25
= 40.50
2-36
If Short Sales Are Not Possible..
Formula still works for an investment asset
because investors who hold the asset will sell it
and buy forward contracts when the forward
price is too low
2-37
2-38
Gold Example (From Chapter 1)
For gold (assuming no storage costs)
F
0
= S
0
(1 + r )
T



If r is compounded continuously instead of annually:
F
0
= S
0
e
rT


2-39
Extension of the Gold Example
For any investment asset that provides no income and has
no storage costs:
F
0
= S
0
e
rT


Example : 3-month forward contract on an exchange fund
bill maturing 1 year from now. The current price of the
exchange fund bill is USD 990.
The 3-month risk free interest rate is 1% per year
(continuously compounded)
F
0
= USD 990 x e
(0.01x3/12)
= USD 992.48
2-40
When an Investment Asset Provides a
Known Dollar Income
F
0
= (S
0
I )e
rT


where I is the present value of the income
Example : 1-year forward contract on an exchange fund note
maturing 5 years from now. Coupon payments of USD 10 every 6
months. The current price of the exchange fund note is USD 990.
The 6-month risk free interest rate is 1% per year
The 1-year risk free interest rate is 1.5% per year

PV of Coupons : 10 x e
(-0.01x0.5)
+ 10 x e
(-0.015)
= USD 19.80

F
0
= USD (990-19.80) x e
(0.015)
= USD 984.86

Similar for forwards / futures on stocks (income = dividends)
2-41
When an Investment Asset Provides a
Known Yield
F
0
= S
0
e
(rq )T


where q is the average yield during the life of the contract
(expressed with continuous compounding)
Example : A asset is expected to provide income of 1% of the asset value
every six months. The term structure of interest rates is flat and interest
rates are 3% per annum (cont comp). The asset price is USD 350.
Yield per annum (semi-annual compounding) = 2%
Yield per annum (continuously compounding) = 1.9901%

F
0
= USD 350 x e
(0.03-0.019901)

= USD 353.5527
( )
R m
R
m
R m e
c
m
m
R m
c
= +
|
\

|
.
|
=
ln
/
1
1
2-42
When an Investment Asset with
storage cost
F
0
= S
0
e
(r+u )T


where u is the average storage cost during the life of the
contract (expressed with continuous compounding)
Example : A asset is expected to incur storage cost of 1% of the asset
value every six months. The term structure of interest rates is flat and
interest rates are 3% per annum (cont comp). The asset price is USD 350.

Storage cost per annum (semi-annual compounding) = 2%
Storage cost per annum (continuously compounding) = 1.9901%

F
0
= USD 350 x e
(0.03+0.019901)
= USD 367.9085 ( )
R m
R
m
R m e
c
m
m
R m
c
= +
|
\

|
.
|
=
ln
/
1
1
2-43
Valuing a Forward Contract
Suppose that
K: is delivery price in a forward contract, this is set at the first
day, and will not change
F
0
is forward price that would apply to the contract today. It
will always change with time changes

The value of a long forward contract, , is
= (F
0
K )e
rT

Similarly, the value of a short forward contract, , is
=(K F
0
)e
rT
2-44
Stock Index
Can be viewed as an investment asset paying a
dividend yield.

The futures price and spot price relationship is
therefore:
F
0
= S
0
e
(rq )T

where q is the dividend yield on the portfolio
represented by the index.
2-45
Index Arbitrage
When F
0
>S
0
e
(r-q)T
an arbitrageur buys the stocks
underlying the index and sells futures.

When F
0
<S
0
e
(r-q)T
an arbitrageur buys futures and
shorts or sells the stocks underlying the index.

2-46
Index Arbitrage (continued)
Index arbitrage involves simultaneous trades in
futures and many different stocks.

Very often a computer is used to generate the trades.

Occasionally simultaneous trades are not possible
and the theoretical no-arbitrage relationship between
F0 and S0 does not hold (see Business Snapshot 5.4)

2-47
A foreign currency is analogous to a security
providing a dividend yield.

The continuous dividend yield is the foreign risk-
free interest rate.

It follows that if r
f
is the foreign risk-free interest
rate.

Futures and Forwards on Currencies
F S e
r r T
f
0 0
=
( )
2-48
What are common underlying assets?
Stocks
Stock indices
Bonds
Currencies
Commodities
Metals
Interest Rates
Other derivatives
...

2-49
Summary of pricing of a contract
Asset Forward/futures price Value of long forward contract with
delivery price K
1
2
3
1: Provides no income
2: Provides known income with present value I
3: Provides known yield q
4: If there is storage cost, we can be treated as negative income or
negative yield.
rT
e S
0
rT
Ke S

0
rT
e I S ) (
0

rT
Ke I S


0
T q r
e S
) (
0
rT qT
Ke e S