Forward and Futures

Contracts
By
Surya B. Rana
THE FORWARD AND FUTURES CONTRACT
Forward contract is an agreement to buy or sell an
asset at a certain future time for a certain price.
It can be contrasted with a spot contract, which is an
agreement to buy or sell an asset today.
A forward contract is traded in the over the counter market
usually between two financial institutions or between a
financial institution and one of its client.
One of the parties to a forward contract assumes a log
position and agrees to buy the underlying asset on a certain
specified future date for a certain specified price. The other
party assumes a short position and agrees to sell the asset
on the same date for the same price.
THE FUTURE CONTRACT ……..
Like a forward contract, a futures contract is an agreement
between two parties to buy or sell an asset at a certain time in
future for a certain price.
 However, unlike forward contracts, futures contracts are
normally traded on an exchange.
Thus futures contracts are contracts for deferred delivery like
forward contracts, but they have four important features that
forward contracts do not have.
 First, futures contract are standardized contracts that trade on
organized exchanges,
 Second, Gains and losses are paid by the parties every day as they
accrue (marking to market process).
 Third, collateral is posted to ensure performance on the contract.
 Fourth, the counter –party in a long positions is not the short,
but an institution set up by exchange called clearinghouse that
has enough capital to make default extremely unlikely.
Forward Vs Futures Contracts……..
Forward Contracts
Private contract between two
parties
Not standardized
Usually has one specified
delivery date
Settled a the end of the
contract
Delivery or final cash
settlement usually takes place
It involves some credit risk
Futures Contracts
Traded on an exchange
Standardized contract
It has a range of delivery date
Settled daily.
Contract is usually closed out
prior to maturity
It has virtually no credit risk
Futures Exchange Examples
The largest exchanges on which futures contracts are
traded are the Chicago Board of Trade (CBOT) and the
Chicago Mercantile Exchange (CME).
On these and other exchanges throughout the world, a
very wide range of commodities and financial assets
form the underlying assets in the various contracts
The commodities include pork bellies, live cattle, sugar,
wool, lumber, copper, aluminum, gold, silver, and tin.
(Commodity Futures)
The financial assets include stock indices, currencies,
and Treasury bonds (Financial Futures).
Some popular futures exchanges in Nepal are
Commodity and Metal Exchange Nepal (COMEN)
and Mercantile Exchange Nepal Limited (MEX).
 Possible Questions
What do you mean by forward contracts and futures
contracts? What are the distinguish features of futures
contracts that forward contracts do not have? Explain.
STRUCTURE OF FUTURES MARKETS

The traders enter into futures contract to buy or to sell

certain asset at future date.
Trader must follow certain procedures fixed by futures
exchange.
The trading procedure starts from giving orders to the
brokers.
This section deals with the general mechanism in the
structure of futures markets (the exchanges which
organize the trading of futures).
1. THE CLEARINGHOUSE AND OPEN INTEREST

Clearinghouse is an independent corporation that

guarantees the every trade in futures exchange.
It acts as an intermediary in futures transactions.
Each futures exchange operates its own independent
clearing-house.
The clearinghouse has a number of clearing member
firms, who must deposit funds with the exchange.
Clearinghouse keeps track of all the transactions that
take place during a day, so that it can calculate the net
position of each of its members.
For an expiring contract, the clearinghouse is the
buyer for seller and seller for buyer.
A clearinghouse member is required to maintain a
margin account with the clearinghouse like an investor
maintaining margin account with a brokerage firm.
The margin deposited by clearing firm is known as
clearing margin.
Gains and losses at the end of the day are settled in the
same way as with the margin accounts of investors.
Open interest on the contract is the number of
contracts outstanding.
When contracts begin trading, open interest is zero.
As time passes, open interest increases progressively
as more contracts are entered.
Almost all traders liquidate their positions before the
contract maturity date.
2. THE MARGIN ACCOUNT AND MARKING TO MARKET
The prospective trader must deposit some funds with
broker before entering into a Futures contract.
This fund is called margin
The objective of margin is to provide a financial
safeguard ensuring that investors will perform their
contract obligations.
The amount of margin may vary from contract to
contract and even broker to broker.
The margin deposit may be in the forms like cash,
bank’s letter of credit and Treasury securities.
There are three types of margins.
First, for each contract, there is initial margin. It is
the amount that must be deposited on the day the
transaction is opened.
This amount is fixed by futures exchange and subject
to change as per exchanges discretion.
To determine the initial margin, exchange usually
considers the degree of volatility of price movement of
underlying asset in the past.
For most of futures contracts, the initial margin may
be 5 percent to 10 percent of the value of underlying
assets.
In Mercantile Exchange Nepal, the initial margin for
one gold contract covering 1 kilogram is Rs 75,000
and for one crude oil contract covering 1 barrel is Rs
70,000 currently.
The initial margin required in 1 kilogram gold futures
contract at Commodity and Metal Exchange Nepal
is Rs 50,000.
The traders must maintain certain amount in their
account during the period in which the contract or
trade is open. This amount is known as maintenance
margin.
This is normally 75 percent of initial margin.
However, it varies from exchange to exchange and
contract to contract.
Once the contract is opened, they are brought to the
market every day and gain or loss on that day due
to change in futures price is settled daily.
If the futures prices move against the investor
resulting in loss, the amount equal to the loss is
deducted from investor’s margin account. This process
is called daily settlement or marking to market the
contract.
If the investor continuously bears loss and balance on
margin account falls below the maintenance margin,
the broker will make a call to the investor asking
him/her to deposit the extra amount. This call is
known as margin call.
Upon margin call, the investor must deposit sufficient
amount to bring the margin balance back to the initial
margin level before starting of trade in next day.
For example, in an investor’s account balance fell below
maintenance margin on Tuesday evening's settlement,
the broker will make a margin call on Tuesday evening or
Wednesday morning. Then the investor must deposit the
amount before the trade starts on Wednesday. This extra
amount deposited is called the variation margin.
If the investor fails to deposit the variation margin,
his/her position will be liquidated (closed) by the
clearing house. The amount remained in the account can
be withdrawn by the investor.
3. CASH VERSUS ACTUAL DELIVERY
When seller wants to make physical delivery or buyer
wants to take delivery, they have to go through certain
procedure.
Delivery usually is a three-day procedure.
Two business days before an intended delivery date, the
holder of the short position (seller) in the contract who
intends to make delivery of underlying asset must notify
the clearinghouse (through broker) of its desire to deliver.
This day is called position day.
The clearing member firm also reports to the
clearinghouse those of their customers who hold long
positions two business days prior to delivery date.
On the next business day, called the notice of
intention day, the exchange selects the holder of long
position to receive delivery.
On the third day, the delivery day, delivery takes
place and the long pays the short.
In case of commodity, taking delivery usually means
accepting a warehouse receipt in return for immediate
payment. The party taking delivery is then responsible
for all warehousing costs.
In case of livestock futures, there may be cost
associated with feeding and looking after the animals.
In case of financial futures, delivery is usually made by
wire transfer. Some financial futures, such as those on
stock indices, are settled in cash because it is
inconvenient or impossible to deliver the underlying
asset.
On cash-settled contracts, the settlement price on last
trading day is fixed at the opening or closing spot price
on the underlying instrument, such as the stock index.
All contracts are marked to market on that day, and the
positions are deemed to be closed.
4. REGULATIONS
Future markets are regulated by the Commodities Futures
Trading Commission in USA.
Regulatory body sets the capital requirements for member
firms of the future exchanges, authorizes trading in new
contracts, and oversees maintenance of daily trading records.
The future exchange may set limits on the amount by which
futures prices may change from one day to the next.
 Till now, there is no any separate act or regulation to
regulate the futures market in Nepal. The transactions are
carrying out on the basis of contract act. Therefore, there is
no position limit and no price limit.
5. TAXATION

Due to the mark to market procedure, investors do

not have control over the tax year in which they
realize gains or losses.
Therefore, taxes are paid at year end on cumulated
profits or losses regardless of whether the position has
been closed out.
Possible Questions
What are the mechanics of futures market? Explain.
Explain the marking to market process and the role of
clearing house in futures market.
 Principles of
Pricing Forward
and Futures
ASSUMPTIONS AND NOTATIONS
In this section, we assume that following are true for
market participants in futures and forward contracts.

 The market participants are subject to no transaction

cost when they trade.
 The market participants are subject to the same tax
rate on all net trading profits.
 The market participants can borrow money at the
same risk-free rate of interest as they can lend money.
 The market participants take advantage of arbitrage
opportunities as they occur.
The following notation will be used to explain
the equilibrium set up of the forward and
futures prices
T = time until delivery date in a forward or futures contract
(in years)
S00 = price of the asset underlying the forward or futures
contract today
F00 = Forward or futures price today
r = Zero-coupon risk-free rate of interest per annum,
expressed with continuous compounding for an investment
maturing at the delivery date (that is, in T years).
Forward Price for an Investment Asset
An investment asset is one that provides the holder with
no income. For example, Non-dividend paying stocks
and zero-coupon bonds are such investment assets.
Strategy:
 If futures price is greater than the spot price of underlying asset, the
investor can buy the asset at present and short sell the futures contract on
the asset (that is F00 > S00erT
rT, long-position on the asset and short position on

the futures).
 If futures price is less than the spot price of underlying asset, the investor
can sell short the asset at present and assume long-position on the futures
contract on the asset (that is F00 < S00erT
rT, short-position on the asset and long

position on the futures).

To generalize this strategy, we consider a forward
contract on an investment asset with Price ‘S00’’ that
provides no income.
Using our notation, the relationship between F0 and S0
is given by:

 F0 = S00erT
rT ...
... (1)
Illustration: Consider a non dividend paying stock is
currently priced at $40 per share. Assume that risk free
rate of interest is 5 percent and a 3-moonth futures on
this stock is priced at $43. What is your investment
strategy with the stock and the futures contract on the
stock?
Since futures price is higher than the spot price of the
underlying stock, you follow the following strategy.
Borrow $40 at risk free-rate for three months to buy the
stock today (S0 = $40).
Sell the futures contract expiring three months from now at
$43 delivery price.
After three months you deliver the stock and get $43
contract price.
How much you need to pay for loan? It is given by
Equation 1

 F00 = S00erT
rT = $40 e0.05 0.25 = $40.50
0.05 xx 0.25

Hence, you give $40.50 after three months to pay off the
loan and your profit is $43 - $40.50 = $2.50
 The Two trading strategies can be summarized as follows:
If Futures price = $43
Action Now
•Borrow $40 at 5% for 3 months
•Buy one unit of asset
•Enter into forward contract to sell
asset in 3 months for $43
Action in 3 months
• Sell asset for $43
• Use $40.50 to repay loan with
interest
Profit realized = $ 2.50
If Futures Price = $39
Action Now
• Short sell 1 unit of asset to realize
$40
• Invest $40 at 5% for 3 months
•Enter into forward contract to buy
asset in 3 months for $39
Action in 3 months
• Buy asset for $39 and close short
position
• Receive $40.50 from investment
Profit realized = $ 1.50
Do yourself?
1. Suppose that you enter into a 6-month forward contract on a non-
dividend paying stock when the stock price is $30 and the risk-free
interest rate with continuous compounding is 12 percent? What
is the forward price? [Ans: $31.86]
2. A 1-year long forward contract on a non-dividend paying stock is
entered into when the stock price is $40 and the risk-free rate of
interest is 10 percent. (a) What is the initial forward price? (b) Six
month later, the price of the stock is $45, what is the is the
forward price? [Ans: (a) $44.21
(b) $47.31]
3. Explain the possible strategies that investors can adopt in futures
trading of investment asset. How investors can reap the profits
from these strategies?