Forward Contract

• Forward Contracts
– Definition: a contract between two parties for
one party to buy something from the other at
a later date at a price agreed upon today
– Exclusively over-the-counter

– Example: A corn flakes manufacturer

(company) and a corn producer (farmer)
agreeing to trade in corn produced at a future
date at a price agreed upon today.
• Futures Contracts
– Forward Contract traded in an exchange

– Definition: a contract between two parties for one

party to buy something from the other at a later date
at a price agreed upon today; subject to a daily
settlement of gains and losses and guaranteed
against the risk that either party might default
– Exclusively traded on a futures exchange
 Organized Futures Trading
Contract Terms and Conditions
– contract size
– quotation unit
– minimum price fluctuation
– contract grade
– trading hours
• Delivery Terms
– delivery date and time
– delivery or cash settlement
 Difference between Futures and
Forwards
  Futures Market Forward Market

Location Futures Exchange No fixed Location

Size of Contract Fixed (standard) Depends on Contract

Maturity Fixed (standard) Depends on Contract

Counterparty Clearing House Known Bank or Client

Valuation Marked-to-Market Everyday No unique Method

Variation Margin Daily None

Regulations Regulated by Exchange Self Regulated

Credit Risk Almost Non Existent Depends on Counterparty

Settlement Through Clearing House Depends on Contract

Liquidation Mostly by Offsetting the positions Mostly settled by actual delivery

 Open Interest And Volume
• Ex-1
Period 1
Trader A Sells one Option Contract and Trader
B buys one Options contract
Period 2
Trader A buys one option contract and trader C
sells one
Period 3
Trader C Buys one option contract and Trader B
sells one Option Contract.
 Open
Time A B C Volume interest

1 Sells 1 Buys 1 1 1

2 Buys 1 Sells 1 1 1

3 Sells 1 Buys 1 1 0
 Open Interest And Volume
• Ex-2
 Open Interest And Volume

• Open Interest is a measure of how many Futures

contract exist at any particular time.

• It shows the number of long positions not squared off or

number of short positions not squared off at any
particular point of time.

• Futures contracts are created and destroyed depending

on how trades are matched up

• Volume Simply measures how many trades occurred.

 Newspaper
• Futures
• Ex: Reliance-September
• Delivery Month
– All contracts of a month expire on the last Thursday of
the month.

• Open high low close

• Value
• No of contracts
• Open Interest and Volume
Futures and Forward Contracts
(cont’d)
The futures market deals with transactions
that will be made in the future.

A person who buys in October a December

Reliance futures contract promises to pay a
certain price for Reliance in December.

If you buy the Reliance today, you purchase

them in the cash, or spot market.
 Problem
• On October 1st
– Reliance Spot Price is Rs. 1000
– Reliance (December Futures/Forward price) = 1050

• On November 10th
– reliance spot price is 1200 and futures price is 1275

• In December at expiration date

– Reliance trades at 1100
 Forward Market

Date Spot Forward( December contract)

1-Oct 1000 1050 ( Mutually Agreed Price)

November 10th 1200 SO what ?

December (Maturity) 1100 Honor the contract

 Pay Off in Forward Market at
Maturity
Payoff of Long futures (if you buy Reliance Forward contract)
=Sell price – Buy price
= Spot price at expiration – forward price
=1100-1050 =50

Pay off of short futures ( if you sell Reliance Forward contract)

=Sell price – Buy price
= Forward Price – Spot price at expiration
=1050-1100= -50

• Because One contract is for 600 shares. Your profit or loss gets
multiplied by 600 times.
 Futures Market

Futures( December
Date Spot contract)

1-Oct 1000 1050

November 10th 1200 1275

December
(Maturity) 1100 1100
 Payoff on Futures Contract at
expiration
Payoff of Long futures (if you buy Reliance Forward
contract)
=Sell price – Buy price
= Spot price at expiration – forward price
=1100-1050 =50

Pay off of short futures ( if you sell Reliance Forward

contract)
=Sell price – Buy price
= Forward Price – spot price at expiration
=1050-1100= -50
 Payoff of Futures Contract on
November 10th
• Payoff of Long futures = Sell price –
Buy price
• = 1275-1050 =225

• Pay off of short futures = Sell price –

Buy price
• = 1050 – 1275= -225
 Futures Contracts (cont’d)
• A futures contract involves a process
known as marking to market
– Money actually moves between accounts
each day as prices move up and down

• A forward contract is functionally

similar to a futures contract, however:
– There is no marking to market
– Forward contracts are not marketable
 Problem
Settlement
Day Price
1 4700
2 4500
3 4650
4 4750
5 4700
The initial margin is set at Rs. 10,000 per contract, while the maintenance
margin is Set at Rs. 8000 per contract. The multiple of each contract is 50.

Calculate the mark-to-market cash flows and the daily closing balances in
Accounts of.
A) An investor who has gone long at 4600 on day ‘0’.
B) An investor who has gone short at 4600 on day ‘0’.
C) Calculate the net profit/loss on each of the contracts.
Investor Who has gone long at 4600 (initial margin =10,000 and Maintenance margin = 8,000)

Opening Mark-to- Is the balance Margin Closing

Day Settlement Price Balance Market < 8000 Call Balance
Bought 50 @
0 4600  10000 - - - 10000

1 4700 10000 5000 NO   15000

2 4500 15000 -10000 YES 5000 10000

3 4650 10000 7500 NO   17500

4 4750 17500 5000 NO   22500

5 4700 22500 -2500 NO   20000

Total Profit/Loss     5000      

Investor Who has gone Short at 4600 (Initial margin =10,000 and Maintenance margin = 8,000)

Mark-to- Is the Closing

Settlement Opening Mar balance Margin Bala
Day Price Balance ket < 8000 Call nce
Sold 50 @
0 4600  10000 - - - 10000

1 4700 10000 -5000 Yes 5000 10000

2 4500 10000 10000 NO   20000

3 4650 20000 -7500 NO   12500

4 4750 12500 -5000 Yes 2500 10000

5 4700 10000 2500 NO   12500

Total
Profit/Loss     -5000      
 BASIS
• The difference between spot price and
futures price is called Basis.

• Basis= Spot Price - Futures Price

 Reliance Spot and Futures Prices

Futures and Spot Price

620

600

580
Futures_Price
560
STOCKPRICE
540

520

500
T 28 27 24 23 22 21 20 17 16 15 14 13 10 9 8 7 6 2 1
Time to Maturity
 Behavior of Basis
• When the futures price is at expiration, the
futures price of reliance and spot price of
reliance must be same.

• That is the basis must be zero.

• This behavior of basis over time is called

convergence
 When basis is constant you get perfect
hedge
Hedge 1; Long in spot and sell in futures  
  Spot Price Futures Price Basis
 before maturity 10 15 -5
 before Maturity 20 25 -5
Profit/Loss 10 -10  

Hedge 2; Short in spot and buy in futures  

  Spot Price Futures Price Basis
 Some time Bef. Mat 10 15 -5
 Before Maturity 20 25 -5
Profit/Loss -10 10  
 Basis Risk

Basis risk arises because basis does not remain constant

• We know that Basis at maturity is always equal to ZERO.

• At the time of purchase of futures contract the basis is either

negative or positive

• You have either positive or negative basis at start and if you hold
the contract until maturity basis will become zero

• Implies Basis rarely will be constant during the holding period of the
contract.
 Basis Risk

Nature Of
hedge   Basis At the start

    Positive Negative
BUY (Futures)
and Hold until
maturity   Favorable Adverse
SELL (Futures)
Hold Until
Maturity   Adverse Favorable
 When Basis is negative at start
Hedge 1; Long in spot and sell in futures
Futures
  Spot Price Price Basis Total P/L
 before mat. 10 15 -5  
 At maturity 20 20 0  
Profit/Loss 10 -5   5
 
Hedge 2; Short in spot and buy in futures  
Futures
  Spot Price Price Basis  
 Before Mat. 10 15 -5  
 At Maturity 20 20 0  
Profit/Loss -10 5   -5
 When Basis is Positive at start
Hedge 1; Long in spot and sell in futures
Futures
  Spot Price Price Basis Total P/L
  20 15 5  
 At maturity 20 20 0  
Profit/Loss 0 -5   -5
 
Hedge 2; Short in spot and buy in futures  
Futures
  Spot Price Price Basis  
  20 15 5  
 At maturity 20 20 0  
Profit/Loss 0 5   5
 Basis Risk

Nature Of
hedge   Basis At the start

    Positive Negative

       

BUY (Futures)   Favorable Adverse

SELL (Futures)   Adverse Favorable

 How are Futures Prices
Determined
• How to determine Futures Prices.
• How are Futures prices related to Spot
Price.
 Models of Futures Prices
• Model No 1
– Cost of Carry Model

• According to this model futures price

depend on the cash price of a commodity
and the cost of storing the underlying
goods from the present to the delivery
date of the futures contract.
 Cost of Carry Model
• The cost of carry model in perfect markets.

• The cost of carry or carrying charge is the total cost to

carry a good forward in time.

• For example, wheat on hand in June can be carried

forward to, or stored until, December
• Carrying charges fall into four basic categories.
– Storage Costs
– Insurance Costs
– Transportation Costs
– Financing Costs
 Cost of Carry Model
• The carrying charge reflects only the charges involved in carrying a
commodity from one time or one place to another.

• The carrying charges do not include the value of commodity itself.

• So, if gold costs $400 per ounce and the financing rate is 1 percent
per month (ignoring other costs),

• the financing charge for carrying the gold forward is $ 4 per month
(1%X$400)

• According to cost of carry model

• Forward Price( maturing in 1 month) = 400 +4 = $404

 Cost of Carry Model
• If FP > spot price + cost of carry

– Investors will indulge in cash and carry arbitrage

– Buy underlying now and sell futures and reverse the
trades at maturity
• IF FP < spot price + cost of carry
– Investors will indulge in reverse cash and carry
arbitrage
– Short Sell underlying asset and buy futures now and
reverse the trades at maturity
 Cost of Carry Model
Assuming Perfect markets and no arbitrage
conditions

FP = spot price + cost to carry

 Cost of Carry Model
• If futures price follow cost of carry model then basis is negative.

• FP = Spot + cost of carry.

• Since Futures price is always more than spot price: Basis is always negative
according to cost of carry model.

• Given FP = Spot price (SP) + Cost to carry (X)

• Basis = Spot price – Futures price

= Spot price – (spot price + x)
= -x
 Contango Market
• When futures price is higher than cash
price then the market is said to be in
“Contango”.
Or
when Basis is negative then Market is said
to be in “Contango”.
Or
When the market follows Full cost of carry
model then it is called “Contango” Market.
Can the Basis be Positive?
 Convenience Yield
• The benefit or premium associated with holding an underlying product or physical
good, rather than the contract or derivative product.

• An example would be purchasing physical bales of wheat rather than future

contracts. Should their be a sudden drought and the demand for wheat increases,
the difference between the first purchase price of the wheat versus the price after
the shock would be the convenience yield.
• When an asset has convenience yield then full cost of carry model does not hold.
• Convenience Yield is a return on holding an Asset

• Anybody who has use of an asset for consumption can derive “Convenience Yield”.
• Ex: Food processor might Derive a convenience yield by holding on to commodity.

• When Futures price is below cash price or spot price then you need to do reverse
cash and carry arbitrage to exploit it.

• But because (say soya beans) has convenience yield there will be no one willing to
lend. Hence short selling of beans will not be possible.
 Backwardation
• When basis is positive then the market is said to be in
backwardation.
• Backwardation is the opposite of contango.
• Backwardation says that as the contract approaches
expiration, the futures contract will trade at a higher price
compared to when the contract was further away from
expiration. This is said to occur due to the convenience
yield being higher than the prevailing risk free rate.

• Expectation Model
– The price of the Futures price is the expected Futures
Spot Price.
 Role of Speculators and
Expectation Model
• If the Futures price were $15 , exceeding
the expected Futures spot price of $10.
Then speculators would sell futures at $
15 and on maturity they would buy back
the futures at $10 and make a profit.

• In effect speculators would make sure that

Futures price is equal to expected Future
Spot Price.
 Who would trade in Futures?
Futures trading will be of interest to those who wish to:

1) Price Risk Transfer - Hedging

2) Invest- Speculating

3) Arbitrage

4) Leverage
Currency Futures- Hedging
 Example – Hedging (Futures)
– Company A must Pay £1 Million in September for imports from Britain.
– Company B will receive £3 Million in September from exports to Britain

• Current Exchange Rate Rs/ £ = 70.2039

• September Futures Price Rs/ £ = 69.9147
• in September at expiration spot price is 71
• Size of Futures Contract £ 62500

• Company A’s Hedging Strategy

– Positing in the SPOT (pay=SHORT)
– Buy (Long) Position in 16 Futures Contracts. This locks in the exchange rate of
69.9147 for the £1 Million it will pay

• Company B’s Hedging Strategy

– Position in the spot (receive=LONG)
– Sell (Short) Position in 48 Futures Contracts. This locks in an exchange rate of
69.9147 for the £3 Million it will receive.
 Company A

Short position in Long Position in Futures

Cash Market market

Time Spot Futures Basis Profit/Loss

Right now 70.2039 69.9147 0.289  

At maturity 71 71 0  

Pay off -0.7961 1.0853   0.2892

 Company B

Long position in Short Position in Futures

Cash Market market
Time Spot Futures Basis Profit/Loss
Right now 70.2039 69.9147 0.2892  
At maturity 71 71 0  
Pay off 0.7961 -1.0853   -0.2892
• Total profit in spot = .7961*3,000,000
=2,388,300

• Total Loss in futures = -1.0853* 48*62500

=-3,255,900

• Net Loss =867,600

 Hedge Ratio
Can I hedge the loss due to basis Risk ?
A ratio comparing the value of futures contracts purchased or sold to
the value of the cash commodity being hedged.

Say you are holding $10,000 in foreign equity, which exposes you to
currency risk. If you hedge $5,000 worth of the equity with a
currency position, your hedge ratio is 0.5 (50 / 100). This means that
50% of your equity position is sheltered from exchange rate risk.

The hedge ratio is important for investors in futures contracts, as it will

help to identify and minimize basis risk.
 Company B

Long position in Short Position in Futures

Cash Market market
Time Spot Futures Basis Profit/Loss
Right now 70.2039 69.9147 0.2892  
At maturity 71 71 0  
Pay off 0.7961 -1.0853   -0.2892
• Instead of 48 futures contracts If Company
B had sold 35.20943 contracts then it
would have resulted in perfect hedge.

Loss in futures =35.20943*62500* (-1.0853)

=-2,388,300
Which is exactly equal to the profit in spot.
• Hedge Ratio = Futures position/Underlying
Asset Position

• Hedge Ratio =35.20944/48

=0.73353 (.7961/1.0853)
=(Change in Spot/Change in futures)

Hence: 35.209 = 0.73* 48 ;

 How to estimate Hedge ratio
Change (St)= alpha + beta *change (Ft) + error term

Change (St) = change in cash price on day t

Change (Ft) = change in futures price on day t

Beta gives the hedge ratio.

Beta = Covariance (S,F) /variance (F) or

Beta = correlation coefficient (S,F)* standard deviation (S)/
Std. dev of (F)
 Speculators
• Exploit the differences in own forecast and
market expectations.
Speculation Using Currency futures
• Problem
– Rs/$ spot = 45.1
– March futures = 45.30
– June Futures = 45.34
– September futures = 45.60

– Mr. A, a forex dealer, holds the view that the market is

wrong and the $ will actually depreciate.
– Another speculator Mr. N agrees with the market that
the dollar will appreciate but thinks that the market is
over estimating the extent of appreciation
– What strategy should they adopt
• Sell futures now and buy back futures later as
they expect the dollar to depreciate.
• Calculate profit and loss if
– if on September 10th following rates prevail.
– Scenario 1
• Spot Rs/$ = 45.5
• September Future = 45.70
– Scenario 2
• Spot Rs /$ = 45.3
• September Future = 45.4
• Assume contract size to be 1 million dollars.
• Scenario 1
– Pay off = Sell price – buy price
=45.6-45.7 = - .1 * 1 million = Loss of 1 lakh

Scenario 2
Pay off = sell price – buy price
=45.6-45.4 = .2 * 1 million = profit of 2 lakhs