Futures

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 Objective

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What are derivatives?
n Forwards, futures, options
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How to trade them?
n How margin account works for futures

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 Alternative ways to buy a stock
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Process has three components
n Fixing the price
n Buyer making payment to the seller
n The seller transferring ownership of the share to the seller
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Alternative ways
n Outright purchase (spot market)
n Fully leveraged purchase
n Prepaid forward contract
n Forward contract

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 The Nature of Derivatives

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A derivative is an instrument whose value depends
on the values of other more basic underlying
variables
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Examples
n Forwards, futures, swaps, options, …
n Underlying:
l Equity, bonds, interest rates, commodities, credits, …

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 Derivatives Markets

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Exchange Traded
n standard products
n trading floor or computer trading
n virtually no credit risk
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Over-the-Counter
n non-standard products
n telephone market
n some credit risk

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 Forward Contracts

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A forward contract is an agreement to buy or sell an
asset at a certain time (the delivery time) in the future
for a certain price (the delivery price)
n It can be contrasted with a spot contract which is an
agreement to buy or sell immediately
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The contract is an over-the-counter (OTC) agreement
between 2 companies
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The delivery price is usually chosen so that the initial
value of the contract is zero
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No money changes hands when contract is first
negotiated and it is settled at maturity

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 The Forward Price

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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)
n The forward price may be different for contracts of
different maturities

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 Terminology

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The party that has agreed to buy has what is termed a long
position
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The party that has agreed to sell has what is termed a short
position
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Example
n On May 6, 2016, the treasurer of a corporation enters into a long
forward contract to buy £1 million in six months at an exchange
rate of 1.5532
l This obligates the corporation to pay $1,553,200 for £1 million on
November 6, 2016
n What are the possible outcomes?

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

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If spot exchange rate in six month
Profit turns out to be , then
n Profit=$46,800
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If spot exchange rate in six month
turns out to be , then 532
n Profit=-$53,200
Price of Underlying at
K Maturity ST

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

Profit
•
If spot exchange rate in six month
turns out to be , then
–
Profit=-$46,800
•
If spot exchange rate in six month
turns out to be , then 532
–
Profit=-$53,200
Price of Underlying at
Maturity, ST
K

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 Issues one related to forward contracts

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Transferability?
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Credit risk?

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 Futures

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Futures - similar to forward but feature formalized and
standardized characteristics
n Agreement to buy or sell an asset for a certain price at a certain time
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Whereas a forward contract is traded OTC a futures contract
is traded on an exchange
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Key difference in futures
n Exchange traded
n Specifications need to be defined:
l What can be delivered,
l Where it can be delivered,
l When it can be delivered
n Settled daily

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 Key Terms for Futures
Contracts

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Futures price - agreed-upon price at maturity
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Long position - agree to purchase
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Short position - agree to sell
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Profits on positions at maturity
Long = spot minus original futures price
Short = original futures price minus spot

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 Types of Contracts

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Agricultural commodities
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Metals and minerals (including energy contracts)
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Foreign currencies
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Financial futures
Interest rate futures
Stock index futures

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 Examples of Futures Contracts

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Agreement to:
n buy 100 oz. of gold @ US$1,250/oz. in December

(COMEX)
n sell £62,500 @ 1.5000 US$/£ in March (CME)

n sell 1,000 bbl. of oil @ US$110/bbl. in April

(NYMEX)

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 Trading Mechanics

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Clearinghouse - acts as a party to all buyers and sellers.
n Obligated to deliver or supply delivery

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 Trading Mechanics …

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Closing out positions
n Reversing the trade
n Take or make delivery
l Delivery - Actual commodity of a certain grade with a delivery
location or for some contracts cash settlement
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Majority of the trades are reversed and do not
involve actual delivery

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 Margin and Trading Arrangements

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Initial Margin - funds deposited to provide capital to absorb
losses
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Marking to Market - each day the profits or losses from the
new futures price are reflected in the account.
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Maintenance margin - an established value below which a
trader’s margin may not fall.
n Margin call - when the maintenance margin is reached, broker will
ask for additional margin funds
l Called variation margin

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 Example of a Futures Trade

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On June 5, An investor takes a long position in 2
December gold futures contracts on COMEX
division of the New York Mercantile Exchange
(NYMEX)
n contract size is 100 oz.
n futures price is US$1250 /ounce
n margin requirement is US$6000/contract (US$12,000 in total)
n maintenance margin is US$4,500/contract (US$9,000 in total)

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 Variation margin

Variation margin

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 Key Points About Futures

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They are settled daily
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Closing out a futures position involves entering into an
offsetting trade
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Most contracts are closed out before maturity
n If a contract is not closed out before maturity, it usually settled
by delivering the assets underlying the contract.
n When there are alternatives about what is delivered, where it is
delivered, and when it is delivered, the party with the short
position chooses.
n A few contracts (for example, those on stock indices and
Eurodollars) are settled in cash
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 Convergence of Futures to Spot

Spot Price
Futures Price

Spot Price Futures

Price

Time Time

(a) (b)

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 Determining Futures Price

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Given the current asset price and risk free interest
rate, can we determine the futures price?

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