FORWARDS & FUTURES

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
Introduction
► Futures and Forward are contracts between
two parties that require specific action at a
later date which is most often the delivery
of the underlying asset. These contracts are
also known as contracts for deferred
delivery.
Forward Contract
►A forward contract is a simple derivative that
involves an agreement to buy/sell an asset on a
certain future date at an agreed price.
► This is a contract between two parties, one of
which takes a long position, agreeing to buy the
underlying asset on a specified future date for a
certain specified price. The other party takes the
short position, agreeing to sell the asset at the
same date for the same price.
Forward Contract
Salient features of a forward contract
 They are bilateral contracts and hence exposed to counter-
party risk.
 Each contract is custom designed, and hence is unique in
terms of contract size, expiration date and asset type and
quality.
 The contract price is not generally available in public
domain.
 On expiration date, the contract has to be settled by the
delivery of the asset.
 If the party wishes to reverse the contract, it has to
compulsorily go to the same counter-party which often
results in high prices being charged.
Forward Contract
► When one orders a car which is not in stock,
from a dealer, one is in fact buying a
forward contract for the delivery of a car.
Forward Contract
► The mutually agreed price in a forward contract is known as
the delivery price.
► The delivery price is chosen in such a way that the value of
the forward contract to both the parties is zero, which means
that it does not cost anything to take either a long or short
position.
► On maturity, the contract is settled so that the holder of the
short position delivers the underlying asset to the holder of
long position, who in turn pays a cash amount equal to the
delivery price.
► It may be noted that while the delivery price contracted
remains the same, the value of contract to the parties
involved is determined by the market price of the underlying
asset. Changes in market price bring about changes in the
contract value.
Forward Contract- Forward Price
► The forward price of a contract is the delivery price which
would render a zero value to the contract. ‘Zero value’
implies that no party is required to pay any amount to the
other when the contract is entered into.
► Upon initiation of the contract the delivery price is so
chosen that the value of the contract is nil i.e. delivery
price and forward price are identical.
► With the passage of time, the forward price would change
& the delivery price would remain unchanged.
► Generally, the forward price at any given time varies with
the maturity of the contract. The forward price of a
contract to buy/sell in one month would be typically
different from that of a contract with a time of three
months or six months maturity.
 Forward Contract- Forward Price
► The pay off from a long position in a forward contract on
one unit of asset is equal to the excess of the spot price of
the asset on the maturity of the contract over the delivery
price.
► Symbolically, if ST be the spot price of the asset at the date
of the maturity and E be the delivery price agreed upon in
the contract then
ST>E ST=E ST<E
Pay off for long position ST-E Gain Break-even Loss
Pay off for short position E-ST Loss Break-even Gain
 Forward Contract- Forward Price
Patterns of Future/ Forward Prices

 If in a market future prices of the assets increase as the

time to maturity increases it is known as normal market.
 If future price is a decreasing function of the maturity it is
known as the inverted market.
 Limitations of the Forward Contract
Forward markets world wide are afflicted with the following
problems:

 Lack of centralization of trading

 Illiquidity
 Counter-party risk.
Futures Contract
► The future contracts represent an improvisation &
provide for trading like forward contracts, but without its
attendant problems.

► Thus future contracts are:

i. Standardized contracts (promise to buy/sell a certain
quantity of standardized good/asset on a future date at
an agreed price)
ii. Between two parties who do not necessarily know each
other.
iii. Guaranteed for performance by an intermediary known
as the clearing corporation or clearing house.
Futures Contract
Thus the future contracts are characterized by:

a) Security
b) Standardized terms and conditions
c) Liquidity
d) Competitive pricing
Futures Contract
 The contract seller is called the short and purchaser is called
the long. Both parties post a performance bond, called the
margin, that is held by the clearing association. Margin
transfers, called variation margin, are made daily in
response to a mark-to-market process based on the daily
settlement prices.
 The purpose of futures contract is not to provide a means
for the transfer of goods. In other words, the property
rights to assets-real & functional-cannot be transferred
through futures contracts. Such contracts enable people to
reduce price risk that they assume in their business.
 Most of the futures contracts get eliminated before the date
of maturity and only an insignificant proportion of them
result in deliveries. Most of the traders cancel their position
by taking reverse positions.
Specifications of Future Contract
In developing a future contract, exchange must specify:
a) The asset
b) The contract size
c) The time of delivery
d) The place of delivery
e) Quotation of price
f) Alternative asset (s), if any, which may be acceptable for
delivery in lieu of particular asset, etc. It is significant
that in case alternatives are provided in the contract, the
person with short position i.e. one which sells it, is
entitled to choose between the alternatives available.
Specifications of Future Contract
g) Quality (in case of commodities) & quantity of the asset.
h) Tick size- the minimum price change.
i) Limits within which the price would be allowed to vary on
a trading day.
j) The contract month.
k) Start of the contract year.
l) Last trading day.
m) Last delivery date.
n) Trading hours.
o) Ticker symbol to identify the asset.
Future Contract-23/12/08
► Margins in forward contract is a ‘performance bond’ and
not equity.
► Its function is to guarantee performance.
► Margin need not be tendered necessarily in cash.
► Larger market players meet their margin requirements with
T- bills or other forms of security.
Future Contract
► Future markets are markets where positions can be taken
without investment. Therefore they are also known as ‘off
balance sheet’ transactions.
Future Contract
► Futures are traded in exchanges similar to stock exchanges. The open
interest means the number of outstanding contracts at any point of
time.
► Open interest position does not necessarily increase with every contract
traded.
 If both the parties to a contract hold positions opposite to the ones
taken in the contract then open interest position would fall by one
contract.
 If none of the parties in the contract are taking an offsetting position,
then open interest position increases.
 If one of the parties to the contract holds no earlier position as in
contract under position, while the other holds a position opposite to the
one held in this contract, then open position interest will not change.
Future Contract
► In futures, clearing house is the counterparty to both
buy/sell transactions and thereby guarantee the delivery
and payment of assets.
► Apart from standing guarantee to each transaction the
clearing house does the matching, processing, registering,
confirming, settling and reconciling all the transactions.
► Margin is determined by the exchange and the clearing
house keeping in mind the expected fluctuation as
deduced from past data.
Future Contract
Initial margin- 5-10% of the value of contract
Margin
Maintenance margin-3/4th of the initial margin

 If initial margin falls below maintenance margin the

investor gets a margin call. The extra funds deposited is
called variation margin.
Future Contract
► The effect of marking to market is that a futures contract
is settled daily instead of being settled at the date of
maturity and has the effect of bringing the value of the
contract back to zero.
► A future contract is closed out and rewritten at a new price
on each trading day.
Divergence of Future and Spot Prices: The Basis

► The difference between the spot price and the future price
is known as the basis. Thus,

basis (b)= spot price of the asset __ future price of contract

to be hedged (S0) used (F0)

In normal markets F0 > S0

In inverted markets F0 < S0
Divergence of Future and Spot Prices: The Basis

As the delivery month approaches, the basis declines until the spot
and future prices are approximately the same. This phenomenon is
known as convergence.
If two are unequal, then arbitrage opportunity exist for traders.
If the future price is higher than the spot price then arbitrageur will
a) Short sell futures contract
b) Buy the asset
c) Make delivery to reap the profit equal to the excess of the future
price over the spot price. As the traders exploit this opportunity the
prices of future will drop.
If the future price is lower than the spot price an investor will buy a
futures contract and take the delivery.
Summary

Exp. Speculator Hedger Pricing Type

Basis
St>Ft +ve Long Short Normal
Backwardation
St<Ft -ve Short Long Contango

St=Ft Zero No gain No gain Efficient

Market