MEB

Financial Strategy

Session 2 – mechanics of forwards and futures

 Forward contracts

• It is a relatively simple derivative

• It is an agreement to buy or sell an asset at a certain future date for a certain price
• This is in contrast to a spot contract, which is an agreement to buy or sell an asset today
• The most commonly used forward contracts are on foreign exchange. The agreement to
buy say $100,000 US at $1.50 to one Euro in three months time. The buyer of the
contract will pay €66,666.67 and receive $100,000. The forward contracts are therefore
engagements to take delivery. They are used to hedge foreign exchange risk
• One can have a forward contract on a stock. The agreement to buy a share of Lafarge at
€101 in three months time. If the stock price in the spot market is €110 at the end of
three months, the forward contract owner will buy the stock at €101 and sell it in the
market and make a profit of €9/stock
• The forward price is dependent on the spot price of the underlying stock

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Foreign Exchange Quotes for GBP, May 26,
2013

Bid Offer
Spot 1.5541 1.5545

1-month forward 1.5538 1.5543

3-month forward 1.5533 1.5538

6-month forward 1.5526 1.5532

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 INTEREST RATE PARITY THEORY
The forward premium or discount equals the
interest rate differential.
• (F - S)/S = (rh - rf)
• where rh = the home rate
• rf = the foreign rate
 INTEREST RATE PARITY THEORY
In equilibrium, returns on currencies will be the
samei. e. No profit will be realized and interest
parity exists which can be written
•

F  1  rh 

S  1  rf 
 Forward Price
• The forward price for a contract is the
delivery price that would be applicable
to the contract if were negotiated today
(i.e., it is the delivery price that would
make the contract worth exactly zero)
• The forward price may be different for
contracts of different maturities (as
shown by the table)

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 Profit from a Long Forward Position (K=
delivery price=forward price at time contract is entered into)

Profit

Price of Underlying at
K Maturity, ST

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Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into)

Profit

Price of Underlying
K at Maturity, ST

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 The Forward Price of Gold (ignores the gold
lease rate)

If the spot price of gold is S and the forward

price for a contract deliverable in T years is
F, then
F = S (1+r )T
where r is the 1-year (domestic currency)
risk-free rate of interest.
In our examples, S = 1400, T = 1, and r
=0.05 so that
F = 1400(1+0.05) = 1470
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 Forward price

• Forward price = Future Value of the Spot price (for assets that provide the
holder with no income), if we assume no transaction costs. Generally the
discount rate is assumed to be the risk free rate

• For an asset that will provide a perfectly predictable known income (for example
stocks with known dividends and coupon bearing straight bonds), the Forward
price = Future Value of the (Spot price - PV of income). Discount rate = risk free
rate

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0
 Forward price

T = Time until delivery (years)

S0 = Spot price of the underlying asset

F0 = Forward price today

r = Risk free rate

I = Present Value of income

F0 = S0er.T

F0 = (S0 − I)er.T

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 Valuing of contracts

• The value of a forward contract at the time it is entered is zero

• At a later stage, it may be positive or negative

• At the start the delivery price is fixed equal to the forward price. As time changes
the forward price changes and therefore the forward contract value also changes

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 Example

• A long forward contract on a non-dividend paying stock was entered into some
time ago. It currently has six months to maturity. The risk free rate of interest
(with continuous compounding) is 10% per annum. The stock price is $25, and
the delivery price is $24. What should be the value of the forward contract?

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 Valuing a forward contract

K = Delivery price in the contract

f = Value of the forward contract today
f = (F0 − K)e−r.T

F0 and f = 0

S0 = 25, K = 24, T = 0.5, r = 10%

F0 = 25e0.1x0.5 = 26.25
f = (26.25 − 24)e−0.1x0.5 = 2.17

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 Futures contracts

• Like a forward contract, a futures contract is an agreement between two parties to buy or sell
an asset at a certain time in the future for a certain price. Unlike forward contracts, futures
contracts are traded on an exchange
• To make trading possible, the exchange has to clearly specify the standardized features of the
contract. As the two parties do not know each other, the exchange also provides a mechanism
that gives guarantees to the buyer and the seller that the contract will be honoured
• The price of any futures contract generally reflects the expected price of the underlying
security as of the settlement date. A primary factor is the current price of the underlying
security
• This is usually based on the principle of mark to market and margin requirements

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 Convergence of Futures price to Spot price

• As the delivery month approaches the futures price converges to the spot price

• Otherwise there is an arbitrage opportunity

• The result is that the futures price is very close to the spot price

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time
(a) (b)
 Example of stock index futures

• A stock index futures contract allows for the buying and selling of the stock
index for a specified price at a specified date. The stock index futures contract
are available on most of the major indexes (S&P 500, FTSE 100, CAC 40)

• The S&P 500 futures contract is valued as the index times $250, so if the index
is valued at 1600, the contract is valued at 1600 x 250 = $400,000. Mini
contracts are also available for small investors (50 instead of 250)

• Participants who expect the stock market to perform well before the
settlement date may consider purchasing the index futures, conversely
investors who expect the stock market to perform poorly before the
settlement date may consider selling the index futures

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 Settlement of index futures

• Stock index futures have fixed settlement dates, usually March, June,
September and December (3rd Friday of the month)
• As the underlying securities are not deliverable, settlement occurs through a
cash payment. On the settlement date, the futures contract is valued according
to the quoted index
• Net gain/loss = Futures price when the initial position is created – Value of the
contract on the settlement date
• Example, the stock index (S&P 500), on the date the position was created is
1550, therefore the price = 1500 x 250 = $375,000. If the index on the date of
settlement is 1600, the contract is worth 1600 x 250 = $400,000. The net gain
to the investor = $25,000

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 Trading of index futures

• Like other futures contracts, stock index futures can be closed out before the
settlement date
• When a position is closed out prior to the settlement date, the net gain or loss
on the futures contract is the difference between the futures price when the
position was created and the futures price when the position is closed out
• Speculators prefer to trade on the futures rather than the actual stocks
because the transaction costs are smaller

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 Exchange-Traded Derivatives (ETD)

• A derivatives exchange is a market where individuals trade standardized

contracts. A derivatives exchange acts as the counterparty to all transactions.
The main objective of an exchange is to ensure that the credit risk is minimized
and transferred to the exchange
• They take initial margins from both sides of the trade to act as guarantee. In
addition they have a system of margin calls, which insures that the
counterparties have sufficient funds to honour their agreements
• Some types of derivatives are traded on the traditional exchanges (convertibles,
pre-emptive rights, warrants)

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 Operations of Margins

• If the investors directly agree to trade an asset in the future for a certain price,
there are obvious counterparty risk. One of the parties involved may not honour the
contract (usually the looser)

• One of the key roles of exchanges is to organize trading so that counterparty risks
are avoided

• This is where the margin accounts come in

• The objective is also to reduce speculation

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 Margins and Mark to Market

• An investor wants to buy Gold Futures contracts in the Commodity Exchange

(COMEX)
• Current futures price of gold is $1,500 per ounce. Contract size is 100 ounces.
Investor has contracted to buy 200 ounces (2 contracts)
• The contract is worth $ 300,000
• The broker will require the investor to deposit funds in a margin account
• Investor must deposit an amount to enter the contract, called Initial Margin
• Suppose this amount is $15000 per contract or $30000 in total
• At the end of each trading day the margin account is adjusted to reflect the
investors gain or loss

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 Margins and Mark to Market

• This principle is called « Mark to Market »

• For instance if the price of gold falls to $1,480 per ounce, the loss will be $4,000
• The balance in margin account will be reduced by $4,000
• If the balance falls below a certain level called maintenance margin, the investor
receives a margin call
• This ensures that there is no counterparty risk

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 Example of a Futures Trade

• An investor takes a long position in 2

December gold futures contracts on June 5
– contract size is 100 oz.
– futures price is US$1,450
– 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)

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 A Possible Outcome

Day Trade Settle Daily Cumul. Margin Margin

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,450.00 12,000
1 1,441.00 −1,800 − 1,800 10,200
2 1,438.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,436.20 −780 −2,760 9,240
7 1,429.90 −1,260 −4,020 7,980 4,020
8 1,430.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,426.90 780 −4,620 15,180

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Role of clearing house

• Guarantees avery dealer’s obligations

UNDERLYI
NG
BUYER SELLER
FUNDS

UNDERLYI UNDERLYI
BUYER NG
C.H. NG SELLER
FUNDS FUNDS
• the C.H is every dealer’s counterpary
• the C.H. Has adequate equity capital
• the C.H. Is protected by the margins architecture system
Margins

 excess Margins
 Possibility to draw funds

 Variation margins
 only in cash
 Delivery

• If a futures contract is not closed out before

maturity, it is 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 28
Commodity futures

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Equity futures

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Fixed income futures

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Bund futures

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 Basis Point Value bond

Basis Point CTD

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 How to determine the hedge ratio: example

PP VN P
n   FC
PCTD VN FUTURE

•ΔPp= 1.59
•ΔPCTD = 1.78
•VNP = 1.000.000
•VNFUTURE = 100.000
•FC= 0.942282

8.4 = (1.59/1.78) * ( 1.000.000/100.000) *

0.942282

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 Example
• It is August. A fund manager has $10 million invested
in a portfolio of government bonds with a duration of
6.80 years and wants to hedge against interest rate
moves between August and December
• The manager decides to use December T-bond
futures. The futures price is 93-02 or 93.0625 and the
duration of the cheapest to deliver bond will be 9.2
years at the futures contract maturity
• The number of contracts that should be shorted is
10,000,000 6.80
  79
93,062.50 9.20

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Limitations of Duration-Based Hedging

• Assumes that only parallel shift in yield

curve take place
• Assumes that yield curve changes are
small
• When T-Bond futures is used assumes
there will be no change in the cheapest-
to-deliver bond
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Euribor futures

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 Eurodollar Futures (Page 140-145)
• A Eurodollar is a dollar deposited in a bank outside the
United States
• Eurodollar futures are futures on the 3-month Eurodollar
deposit rate (same as 3-month LIBOR rate)
• One contract is on the rate earned on $1 million
• A change of one basis point or 0.01 in a Eurodollar
futures quote corresponds to a contract price change of
$25

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 Eurodollar Futures continued
• A Eurodollar futures contract is settled in
cash
• When it expires (on the third Wednesday
of the delivery month) the final settlement
price is 100 minus the actual three month
Eurodollar deposit rate

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futures: example of short-term money market

 complete Info  Prices

 OPEN INTERE

 VOLUMES of TRA

 SETTLEMENT

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Forward Contracts vs Futures Contracts

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash Contract usually closed out

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

Options, Futures, and Other Derivatives,

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9th Edition, Copyright © John C. Hull 2014