Futures and Forwards

1. Futures and Forwards Shannon Woolley

2. What is a Futures Contract? • A standardized, transferable contract between two parties that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date • Traded on an exchange • Agree today on the future price of a product • Fair Price

3. Origin • Solution to supply and demand of crops • 1730s: Dōjima Rice Exchange in Japan • 1848: Chicago Board of Trade was formed • First traded forward contracts • Weren’t being honored by both buyer and seller • 1865: “Standardized” futures contracts were introduced

4. Standardized • Standardization helps ensure their liquidity • Usually will specify: • Underlying asset and amount • Currency quoted in contract • Quality • Delivery month • Last trading date

5. Futures Market • Auction market where participants buy and sell futures contracts • Exchange trading floors • Divided into pits • Open outcry • Hand signals • Electronic Trading • Trading Pit

6. Profits and Losses • Calculated using Mark-to-Market practice • Depend on the daily movements of the market • Differs from the stock market • Gains and losses aren’t realized until investor decides to sell stock • Futures are calculated on a daily basis • Each day gains and losses from a day’s trading are credited or deducted to a person’s account

7. Margin • Margin: fraction of the value of contract the trader must pay • Usually 10%-15% , sometimes less • Increases leverage • Futures market margin: the amount of money you have to put up to control a futures contract • Initial margin: minimum amount of money you must deposit to open a futures contract • Maintenance margin: lowest amount account can reach before needing add more money

8. Delivery • Physical Delivery: the specified amount of the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract • Cash Settlement: parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires • Most transactions are settled in cash

9. Delivery • Once settled in cash, the actual physical commodity is bought or sold in the cash market • Cash market (spot market): market where bought and sold assets are delivered immediately • In most cases, delivery never takes place • Buyer and seller liquidate their long and short positions before contract expires • Buyer sells futures • Seller buys futures

10. Example of Futures Contract • Farmer selling lettuce to McDonald’s • Current Price = $2 per bushel • Create futures contract, determine fair price • Decide on 5 million bushels at $3 per bushel • Profits/Losses calculated on daily basis • Expiration in December, bad season, lettuce supply low causing price to rise to $5 per bushel • Final exchange: $2 difference from futures price • McDonald’s still only pays future price ($3) so they profit • Farmer’s loss is offset – can now sell lettuce at higher price

11. Players and Positions • Hedgers: want to secure price of commodity to reduce risk • Speculators: want to increase their risk to maximize their profits • Important to have both • Often take opposite sides • Helps create supply/demand equilibrium • Buyer assumes the long position • Seller assumes the short position

12. Players and Positions

13. Risk Involved • Risk to both buyer and seller is unlimited • Small margins high leverage • Small movements in price of futures contract can cause very large losses • Loss may exceed the amount of the initial margin • Loss could also exceed the entire amount deposited in the account or more • No cutoff price • Big Risk!

14. Why invest in a Futures Contract? • Big risk means big rewards • Leverage can work in your favor • End up with huge gains • No default risk – exchange acts as counterparty • Guaranteeing delivery and payment via clearing house • Clearing house protects itself by requiring counterparties to mark to market their positions daily • Reduces risk when making purchases • Pre-set price, know maximum they would have to pay

15. Pricing • FV = Futures price • S = Spot index price • r = riskless interest rate • d = Dividends to expiration of futures • t = number of days from today's spot value date to the value date of the futures contract

16. Example Theoretical Fair value for S&P 500 futures: • S = 1146.00 pts • r= 5.7% • D= 3.47 pts (converted to S&P points)  • t= 78 days • FV = 1146 [1+.057 (78/360)] - 3.47 = 1156.68 pts • S&P 500 listed FV = 1157.00 pts

17. Forward Contract • A non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today • Highly customized • Transactions take place in large, private, unregulated markets • Ex: banks, investment banks, government and corporations

18. Forward vs. Futures Very similar to futures contracts but also differ: • Costs nothing to enter a forward contract • Settled at forward price agreed on at trade date • i.e. The price decided at start • Futures settle on last trading date • Not exchange-traded • Over the counter (OTC) • Not standardized • No cash flows until delivery • i.e. No margin requirements

19. Risks • Credit risk • Depend on the counterparty to deliver the asset • If counterparty defaults, your loss • Credit exposure can keep increasing because the profit/loss is only realized at the time of settlement • Market Risk • Little or no market liquidity

20. Pricing • At the initial open of a forward contract, the forward price makes the value of the contract zero • If value of underlying changes, value becomes positive or negative, depending on position held • Example: • John wants to buy Bob’s boat in a year. • They create a forward contract in which Bob sells his boat to John for $50,000 a year from now. • At the end of the year, the boat is worth $60,000, but Bob still must sell it for $50,000. • John profited $10,000 while Bob lost $10,000

21. Pricing • The Forward Price can be determined by the following formula:  • F0= Forward price of the asset at time T • S0= Current spot price of the asset • r = riskless interest rate

22. The Future of Futures Contracts • In 2006, New York Stock Exchange teamed up with the Amsterdam-Brussels-Lisbon-Paris Exchanges • “Euronext” electronic exchange • Formed first trans-continental Futures and Options Exchange • Also, there’s been sharp growth of internet Futures trading platforms • What do these developments mean? • Total internet trading of Futures and Options in the coming years

23. Works Cited Campbell, Harvey. "Futures Contract." Financial Glossary, 2004. Web. 1 Nov. 2010. <http://financial-dictionary.thefreedictionary.com/Futures+Contract>. Constable, Simon. “How to trade Commodity Futures.” TheStreet. TheStreet.com Inc., 2007. Web. 2 Nov 2010. <http://www.thestreet.com/story/10390453/1/how-to-trade-commodity-futures.html>. "Futures Contract." Investopedia’s Guide To Wall Speak, Edited by Jack Guinan. Investopedia, 2009. Web. 3 Nov 2010. <http://financial-dictionary.thefreedictionary.com/Futures+Contract>. "Futures Contract." Wikipedia. Wikimedia Foundation, Inc., 2010. Web. 29 Oct 2010. <http://en.wikipedia.org/wiki/Futures_contract>. Hull, John. Options, Futures and other Derivatives. Prentice-Hall, 2000. Milton, Adam. "Futures Trading - How Futures are Traded." About.com. New York Times Company, n.d. Web. 1 Nov 2010. <http://daytrading.about.com/od/futures/a/HowAreFuturesTr.htm>.