Mechanics of Forward and Futures Contracts

1. Unit 2 Mechanics of Forward and Futures Contracts By Noura ben Mbarek

2. Forward Contracts It is an agreement to buy or sell an asset at a certain future time for a certain price. It is traded in the over-the-counter market—usually between two financial institutions or between a financial institution and one of its clients.

3. Profit Price of Underlying at Maturity, ST Profit from a Long Forward Position (K= delivery price=forward price at time contract is entered into) K

4. Profit Price of Underlying at Maturity, ST Profit from a Short Forward Position (K= delivery price=forward price at time contract is entered into) K

5. 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 normally traded on an exchange. To make trading possible, the exchange specifies certain standardized features of the contract. As the two parties to the contract do not necessarily know each other, the exchange also provides a mechanism that gives the two parties a guarantee that the contract will be honored.

6. 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

7. Convergence of Futures to Spot Futures Price Spot Price Futures Price Spot Price Time Time (a) (b)

8. 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 daily settlement • Margins minimize the possibility of a loss through a default on a contract

9. Margin Cash Flows • A trader has to bring the balance in the margin account up to the initial margin when it falls below the maintenance margin level • A member of the exchange clearing house only has an initial margin and is required to bring the balance in its account up to that level every day. • These daily margin cash flows are referred to as variation margin • A member is also required to contribute to a default fund

10. 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)

11. Possible outcome

12. Margin Cash Flows When Futures Price Increases Clearing House Clearing House Member Clearing House Member Broker Broker Short Trader Long Trader

13. Margin Cash Flows When Futures Price Decreases Clearing House Clearing House Member Clearing House Member Broker Broker Long Trader Short Trader

14. Some Terminology • Open interest: the total number of contracts outstanding • equal to number of long positions or number of short positions • Settlement price: the price just before the final bell each day • used for the daily settlement process • Volume of trading: the number of trades in one day

15. Key Points About Futures • They are settled daily • Closing out a futures position involves entering into an offsetting trade • Most contracts are closed out before maturity

16. 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

17. Questions • When a new trade is completed what are the possible effects on the open interest? • Can the volume of trading in a day be greater than the open interest?

19. Types of Orders Discretionary Time of day Open Fill or kill • Limit • Stop-loss • Stop-limit • Market-if touched

20. Foreign Exchange Quotes • Futures exchange rates are quoted as the number of USD per unit of the foreign currency • Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are quoted as USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.

21. Example The forward price on the Swiss franc for delivery in 45 days is quoted as 1.1000. The futures price for a contract that will be delivered in 45 days is 0.9000. Explain these two quotes. Which is more favorable for an investor wanting to sell Swiss francs?

22. Exercise 1 Suppose that you enter into a short futures contract to sell July silver for $17.20 per ounce. The size of the contract is 5,000 ounces. The initial margin is $4,000, and the maintenance margin is $3,000. What change in the futures price will lead to a margin call? What happens if you do not meet the margin call?

24. Exercise 2 At the end of one day a clearing house member is long 100 contracts, and the settlement price is $50,000 per contract. The original margin is $2,000 per contract. On the following day the member becomes responsible for clearing an additional 20 long contracts, entered into at a price of $51,000 per contract. The settlement price at the end of this day is $50,200. How much does the member have to add to its margin account with the exchange clearing house?