Lecture02 FWD Fut Basics Handout

Forwards and futures
Futures markets
Hedging with forwards and futures
Derivatives and Risk Management

Lecture 2: Basics of forwards and futures
Charlotte Sun Clausen-Jørgensen and Søren Hesel
Department of Business and Management
Fall 2022
1 / 17
Futures markets
Outline
1 Forwards and futures
2 Futures markets
3 Hedging with forwards and futures
2 / 17
Futures markets
Forwards vs. futures

Source: Hull’s Table 2.3 (p. 65)
Forwards Futures
Private contract between 2 parties Exchange traded
Non-standard contract Standard contract
Usually 1 specified delivery date Range of delivery dates available
Settled at the end Settled daily
Delivery or final cash settlement Contract usually closed out prior to
usually occurs maturity
Some credit risk Virtually no credit risk
For many purposes the differences do not matter much!
3 / 17
Forwards and futures Specification of a futures contract
Futures markets Marking-to-market and margins
Hedging with forwards and futures A preview on forward and futures prices
What needs to be specified?
• The underlying asset and contract size – what can be delivered?

I For commodities: quality specification, maybe some discretion to
the party with the short position
I For some bond futures in the U.S.: choice between several bonds
• Delivery arrangements – where can it be delivered?
I Important for commodities
• Delivery months – when can it be delivered?
I For most futures, delivery can take place throughout a given month
I Most futures are “closed out” before maturity—by entering the
opposite futures contract—so that no delivery takes place
Similarly for forwards. . .
4 / 17
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 the
marking-to-market (= the daily settlement)
• Margins reduce the risk of default on a contract
• Initial margin: Deposit when the contract is entered into
• Maintenance margin: Minimum balance on the margin account
• If the balance of the margin account falls below the maintenance
the investor gets a “margin call” and has to bring the balance
back to the initial margin
• The level of the initial and the maintenance margin may depend
on the type of trade
• Often some interest rate on the margin account
5 / 17
Marking-to-market of futures
– Example (similar to Hull p. 51–52)
An investor takes a long position in two December gold futures

contracts on June 5:
• contract size is 100 oz.
• futures price is US$1,250/oz.
• initial margin requirement is US$6,000/contract (US$12,000 in
total)
• maintenance margin is US$4,500/contract (US$9,000 in total)
6 / 17
Marking-to-market of futures, cont’d

– Example (similar to Hull, Table 2.1)
Day Trade Settle Daily Cumul. Margin Margin

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1, 250.00 12, 000
1 1, 241.00 −1, 800 −1, 800 10, 200
2 1, 238.30 −540 −2, 340 9, 660
... ... ... ... ...
6 1, 236.20 −780 −2, 760 9, 240
7 1, 229.90 −1, 260 −4, 020 7, 980 4, 020
8 1, 230.80 180 −3, 840 12, 180
... ... ... ... ...
16 1, 226.90 780 −4, 620 15, 180
Buzz time. . .
Construct your own example from historical data. The following
websites may be useful:
• Historical data: https://www.investing.com
• Contract specs and margins: http://www.cmegroup.com
7 / 17
Forward price on a non-dividend paying asset

Consider a long position in a forward contract on a non-dividend
paying asset with price denoted by S. The continuously compounded
risk-free interest rate is r .
With delivery at time T at a delivery price of K :

Payoff = ST − K .
Present value (at time t < T ) of payoff is (why?)

PVt = St − Ke−r (T −t) .
Solving PVt = 0 for K gives K = St er (T −t) so the forward price is
FtT = St er (T −t) .
Obviously(?) FTT = ST .
8 / 17
Futures price on a non-dividend paying asset
Let ΦTt denote the futures price at time t for a contract with last
settlement at time T
• On the last trading day: futures = forward so ΦTT = FTT = ST

“convergence of futures to spot”
• The futures price at any earlier day is used only for the
marking-to-market payment the following day
⇒ Recursive valuation problem—much harder than finding the
forward price!
• Under some circumstances ΦTt = FtT (see Hull, Chp. 5) but in
general ΦTt 6= FtT (see Munk, Chp. 6)
9 / 17
Patterns of futures prices
At a given day t, consider how futures prices ΦTt vary with the final
settlement day T (sometimes called “the futures curve”)
• Markets where ΦTt is increasing in T (in particular, ΦTt > St ) are
known as normal markets
• Markets where ΦTt is decreasing in T (in particular, ΦTt 6 St ) are
known as inverted markets
Practice questions:
• If ΦTt = FtT = St er (T −t) , is the market normal or inverted?
10 / 17
Risk-free profits in futures markets?
Suppose that there are no storage costs for crude oil and the interest
rate for borrowing and lending is 5% per annum. How could you make
money on May 21, 2020, by trading July 2020 and December 2020
contracts? Use Table 2.2.
From Table 2.2:

• Futures price for July 2020: 33.96
• Futures price for December 2010: 35.76
• Think of the futures as being forwards ΦTt = FtT = St er (T −t)
• Then ΦTt 2 = St er (T2 −t) = St er (T2 −T1 +T1 −t) = ΦTt 1 er (T2 −T1 )
• If ΦTt 2 6= ΦTt 1 er (T2 −T1 ) ⇒ arbitrage / risk-free profit
11 / 17
Perfect hedge
Futures markets
Basis and basis risk
Perfect hedge with forwards
“Perfect hedge”: eliminates all uncertainty about future value
• Long hedge: If you know you will purchase an asset at a future

date, you can lock in the purchase price by taking a long position
in a forward on that asset
• Short hedge: If you know you will sell an asset at a future date,
you can lock in the selling price by taking a short position in a
forward on that asset
number of forwards or futures used in the hedge NF

Hedge ratio = number of units of the underlying asset = NA
Note: For a perfect hedge using forwards, the hedge ratio is 1, but
what about futures?
12 / 17
Perfect hedge
Futures markets

Not always possible to find a forward/futures contract that gives a
perfect hedge
• Mismatch in dates
I maybe you do not know exactly when you need to buy/sell the
underlying asset
• Mismatch in position size
Example: you need to hedge a position in 320,000 lbs soybeans
but each soybean futures is on 60,000 lbs
• Mismatch in assets: maybe you cannot get a forward/futures on
the asset you want to, but only on a “similar” asset
Basis: the difference between spot price and futures price
Basis risk: uncertainty about the basis when the hedge is closed out
A perfect hedge carries no basis risk.

13 / 17
Perfect hedge
Futures markets
Reducing basis risk in futures hedges
Choice of futures contract:

• Choose a delivery month that is as close as possible to, but later
than, the end of the life of the hedge
I Sometimes necessary to “roll the hedge forward” using a sequence
of short-term futures contracts over the life of the hedge
• No futures on the asset being hedged? Choose the contract
whose futures price is most highly correlated with the asset price
cross hedging
How do we find the optimal hedge ratio?
One solution: Minimize the variance of the hedger’s position
14 / 17
Perfect hedge
Futures markets
Minimum variance hedging

Suppose that NA units of an asset is expected to be sold at time t2 ,
and consider entering a hedge at time t1 < t2 by shorting futures
contracts on NF units of a similar asset.
The total amount realized for this strategy is

NA · St2 − NF · (FtT2 − FtT1 ) = NA · St1 + NA · (St2 − St1 ) −NF · (FtT2 − FtT1 )
| {z } | {z }
∆S ∆F
The minimum variance hedge ratio is (computations on the board)

σ
h∗ = ρ S
σF
p p
where σS = Var(∆S), σF = Var(∆F ), and ρ = Corr(∆S, ∆F ).
The minimum variance is

v = (1 − ρ2 )NA2 σ2S
15 / 17
Perfect hedge
Futures markets
Minimum variance hedging, cont’d

Note:
• If FtT = St er (T −t) , then ρ = 1 and σF = σS er (T −t) over the next
short period
I v = 0: perfect hedge!
I h∗ = e−r (T −t) is less than one! (“Tailing the hedge”)
I Gradually increase the number of futures contracts as the final
delivery/settlement approaches
I Difference between hedging with forwards and hedging with futures
• Relation to linear regression:
∆S = α + β∆F + ε ⇒ cov(∆S, ∆F ) = βσ2F

cov(∆S, ∆F ) σS σ
⇒β= =ρ S
σS σF σF σF
optimal hedge ratio is the slope in a linear regression of ∆S on

∆F
16 / 17
Perfect hedge
Futures markets
The optimal number of futures contracts
• QA : the size of position being hedged (units)

• QF : the size of one futures contract (units)
• N ∗ : Optimal number of future contracts for hedging
• Then the total number of future contracts is given by
h ∗ QA
N∗ =
QF
17 / 17

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Forwards and futures

Derivatives and Risk Management

Charlotte Sun Clausen-Jørgensen and Søren Hesel

Department of Business and Management

1 Forwards and futures

3 Hedging with forwards and futures

Forwards vs. futures

For many purposes the differences do not matter much!

What needs to be specified?

• The underlying asset and contract size – what can be delivered?

Similarly for forwards. . .

An investor takes a long position in two December gold futures

Marking-to-market of futures, cont’d

Day Trade Settle Daily Cumul. Margin Margin

Forward price on a non-dividend paying asset

With delivery at time T at a delivery price of K :

Present value (at time t < T ) of payoff is (why?)

Solving PVt = 0 for K gives K = St er (T −t) so the forward price is

Futures price on a non-dividend paying asset

• On the last trading day: futures = forward so ΦTT = FTT = ST

Patterns of futures prices

Risk-free profits in futures markets?

From Table 2.2:

Perfect hedge with forwards

“Perfect hedge”: eliminates all uncertainty about future value

• Long hedge: If you know you will purchase an asset at a future

number of forwards or futures used in the hedge NF

Basis and basis risk

Basis: the difference between spot price and futures price

A perfect hedge carries no basis risk.

Reducing basis risk in futures hedges

Choice of futures contract:

How do we find the optimal hedge ratio?

One solution: Minimize the variance of the hedger’s position

Minimum variance hedging

The total amount realized for this strategy is

The minimum variance hedge ratio is (computations on the board)

The minimum variance is

Minimum variance hedging, cont’d

∆S = α + β∆F + ε ⇒ cov(∆S, ∆F ) = βσ2F

optimal hedge ratio is the slope in a linear regression of ∆S on

The optimal number of futures contracts

• QA : the size of position being hedged (units)

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