FORWARD AND

FUTURES

BY POOJA GUPTA
 Futures and Forwards

A future is a contract between two parties

requiring deferred delivery of underlying
asset (at a contracted price and date) or a
final cash settlement. Both parties are
obligated to perform and fulfill the terms.
A customized futures contract is called a
Forward Contract.
 Why Forwards?

They are customized contracts unlike Futures

and they are:
 Tailor-made and more suited for certain
purposes.
 Useful when futures do not exist for commodities
and financials being considered.
 Useful in cases futures’ standard may be different
from the actual.
 Futures & Forwards
Distinguished
FUTURES FORWARDS
They trade on exchanges Trade in OTC markets
Are standardized Are customized
Identity of counterparties Identity is relevant
is irrelevant
Regulated Not regulated
Marked to market No marking to market
Easy to terminate Difficult to terminate
Less costly More costly
 Important Terms

 Spot Markets: Where contracts for

immediate delivery are traded.
 Forward or Futures markets: Where
contracts for later delivery are traded.
 Both the above taken together constitute
cash markets.
A. Forward vs. Futures Markets
 1. Forward contracting involves a contract
initiated at one time and performance in
accordance with the terms of the contract
occurring at a subsequent time.
– Example: A highly prized St. Bernard has just given birth to a
litter of pups. A buyer agrees to buy one pup for $400. The
exchange cannot take place for 6 weeks. The buyer and seller
agree to exchange (sell) the pup in 6 weeks for $400. This is a
forward contract; both parties are obligated to go through with
the deal.

6
 A. Forward vs. Futures Markets
(continued)
 2. Differences b/w Forward and Futures Markets
– a. The Organized Exchange
– b. Contract Terms--standardized item
– c. The Clearinghouse--takes no active position in the
market, but interposes itself between all parties to
every transaction. The number of contracts bought
must always equal the number of contracts sold.

7
 A. Forward vs. Futures Markets
(continued)
– d. The Requirement for Daily Resettlement
• Assume that the contract closes on May 2 at
168¢/bushel. This means that A has sustained a loss
of 3¢. Since there are 5000 bu. in the contract this
represents a loss of $150. This amount is deducted
from the margin deposited with the broker.

8
A. Forward vs. Futures Markets
(continued)
• Assume initial margin was $1400 and
maintenance margin is $1100. A has already
sustained a loss of $150 so the value of the
margin account is $1250. If the price drops by
4¢ the following day another $200 loss is
registered. The value of the margin account is
down to $1050, below the maintenance
margin. This means A will be required to
bring the margin account back to $1400.

9
 Table 1
 Futures Market Obligations. The oat
contract is traded by the CBT. Each
contract is for 5000 bushels, and prices
quoted in cents per bushel.

10
 Table 1 (continued)
A B
May 1:
Buys 1 Sept. contract for Sells 1 Sept. contract for
oats at 171 cents/bushel oats at 171 cents/bushel
A Clearinghouse
Buys 1 Sept. contract for Agrees to deliver to A a
oats at 171 cents/bushel Sept. 1 contract for oats at
171 cents/bushel
B Clearinghouse
Sells 1 Sept. contract for Agrees to receive from B a
oats at 171 cents/bushel 1 Sept. contract for oats at
171 cents/bushel 11
 Table 1 (continued)

 3. A Reversing Trade--brings a trader’s net

position in some futures contract back to
zero. Without a reversing trade the
investor will be required to either deliver
the product at the contract price (if the
contract was sold) or purchase the product
(if the contract was purchased).

12
 B. Purposes of Futures Markets

– Meets the needs of three groups of futures

market users:
• 1. Those who wish to discover information about
future prices of commodities (suppliers)
• 2. Those who wish to speculate (speculators)
• 3. Those who wish to transfer risk to some other
party (hedgers)

13
 A. Reading Futures Prices
(Contracts)
– 1. The Product
– 2. The Exchange
– 3. Size of the Contract
– 4. Method of Valuing Contract
– 5. The delivery month

14
 A. Reading Futures Prices
(Prices)
– 1. Opening
– 2. High
– 3. Low
– 4. Settlement
• Price at which the contracts are settled at the
close of trading for the day
• Typically the last trading price for the day

15
 B. The Basis
 ...is the current cash price of a
particular commodity minus the price
of a futures contract for the same
commodity.
 BASIS = CURRENT CASH PRICE - FP

16
 B. The Basis (continued)
 Example: Gold Prices and the Basis:
12/16/03
Basis
Cash $441.00
DEC 441.50 -.50
MAR ‘04 449.20 - $7.70
JUN 459.40 -$17.90
SEP 469.90 -$28.40
DEC 480.70 -$39.20
MAR ‘05 491.80 -$50.30
17
 B. The Basis (continued)

Prices

Cash

Basis Futures

Time
Present Maturity
18
 B. The Basis (continued)
 1. Relation between Cash & Futures
 2. Spreads
– The difference between two futures
prices (same type of contract) at two
different points in time

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 Swaps

Swaps involve exchange of one set

of financial obligations with another e.g.
fixed rate of interests with floating rate
of interest, one currency obligation to
another, a floating price of a commodity
to fixed price etc.
 History of Swaps
First currency swap was engineered in
London in 1979, but the next deal structured by
Salomon Brothers in 1981 in London involving
organizations of the stature of World bank and
IBM, not only ended the 2-year obscurity but
also gave credibility to the instrument, so
necessary for its extremely fast growth.
 History of Swaps

First Interest rate swap was engineered

in London in 1981and was introduced in
the US in 1982 by Student Loan
Marketing Association (Sallie Mae).
Commodity swaps were first engineered
in 1986 by Chase Manhattan Bank.
 Purpose of a Swap
 Reduce cost of capital
 Manage risk
 Exploit economies of scale
 Arbitrage across capital markets
 Enter new markets
 Create synthetic instruments
 Basic Types of Swap

 Interest Rate Swaps

 Currency Swaps
 Commodity Swaps

Interest rate swaps and currency swaps

are together known as Rate Swaps.
 Rate Conventions
 Swaps are most often tied to LIBOR.
 It is quoted “actual over 360”, as though the year
is of 360 days. This raises the effective rate for a
period and has compounding effect.
 Bond equivalent yields are quoted on actual over
365 days.
 For comparison, adjustments can be made by
multiplication of a rate differential by 365/360 or
by 360/365.
 Cash Market Transactions
Swaps are used in conjunction with
following basic cash market transactions:

 Obtain actuals from cash market

 Make/receive payments to/from cash
market
 Supply actuals to cash market
 Initial Exchange of Notionals
.
(Optional)

Notionals Notionals
Swap
Counterparty A Counterparty B
Dealer
Notional Notionals
 Periodic Usage or Purchase Payments
(Required)
.

Fixed Price Fixed Price

Swap
Counterparty A Counterparty B
Dealer
Floating Floating
Price Price
.
Re-exchange of Notionals
(Optional)

Notionals Notionals
Swap
Counterparty A Counterparty B
Dealer
Notionals Notionals
 Interest Rate Swap
 A, desirous of 10-yr fixed rate debt (available at
11.25% sa) has access to cheap floating rate
financing (LIBOR + 50bp).
 B, desirous of a 10-yr floating rate financing
(available at LIBOR) has access to cheaper fixed
rate financing (10.25% sa).
 A dealer available can be a floating rate payer or
receiver at LIBOR and a fixed rate payer at
10.40% sa and receiver at 10.50% sa.
 Interest Rate Swap

.
CASH MARKET TRANSACTIONS
Debt market
Principal (Floating Rate)

Debt Market
(Fixed Rate) Principal

Swap
Counterparty A Counterparty B
Dealer

SWAP
 Interest Rate Swap
CASH MARKET TRANSACTIONS
.

Debt market
6-M LIBOR +50bps
(Floating Rate)

Debt Market
(Fixed Rate) 10.25% (sa)

10.50% (sa) 10.40% (sa)

Swap
Counterparty A Counterparty B
Dealer
6-M LIBOR 6-M LIBOR

SWAP
 Interest Rate Swap

.
CASH MARKET TRANSACTIONS
Debt market
Principal (Floating Rate)

Debt Market
(Fixed Rate) Principal

Swap
Counterparty A Counterparty B
Dealer

SWAP
 Currency Swap
 A, needing floating rate dollars, can borrow euros
at 9.0% fixed and dollars at 1-yr LIBOR floating.
 B, needing fixed rate euros, can borrow euros at
10.1% fixed and dollars at 1-yr LIBOR floating.
 Swap dealer can pay 9.45% fixed on euros
against dollar LIBOR and dollar LIBOR against
9.55% fixed on euros.
 Currency Swap
CASH MARKET TRANSACTIONS
.

Debt market
9%
(Euro)

Debt Market
($) LIBOR

9.45% 9.55%
Swap
Counterparty A Counterparty B
Dealer
LIBOR LIBOR

SWAP
 Commodity Swap
 A crude oil producer wants to fix a price to be
received for 5 years on production of 8000 barrels
p.m. He agrees to pay average of preceding month
price to swap dealer against a receipt of
$68.20/barrel.
 An oil refiner wants to fix the price he pays for oil
for 5 years on his average need of 12000 barrels. He
agrees to pay $68.40 against market price of
$69.50/barrel for an average price of preceding
month.
 Commodity Swap
.
CASH MARKET TRANSACTIONS

Spot
Actuals Oil Actuals
Market
Spot Price Spot Price

$68.20/barrel $68.40/barrel
Swap
Counterparty A Counterparty B
Dealer
Spot Price Spot Price
(average) (average)
Oil Producer Refiner
SWAP
 Why a Swap Dealer?
If A and B attempted a swap with each
other directly, it would have failed due
to different requirements. Swap dealer
can be a fixed-rate payer on 4000
barrels and till such time he can hedge
in futures.
 Swaption

When a firm doesn’t want a swap now

but can lock-in the terms of swap now by
buying an option on swap called
Swaption.