Forwards and Futures

Anshul Jain
What are Derivatives ?
 Forwards
• Agreement to buy or sell an asset on a specified
date for a specified price
• Custom contracts
• Contract price -> private information
• Usually delivery settlement
• Closing out is difficult
• Lack of centralised trading
• Illiquidity
• Bilateral -> counterparty risk
 Futures
• Similar to forwards, but standardised
• Quantity of the underlying
• Quality of the underlying
• The date of delivery
• Units of price quotes and tick size
• Settlement location
 Distinction
Futures Forwards
Trade on organised exchange OTC in nature
Standardised contract terms Customised contract terms
More liquid Less liquid
Requires margin payments No margin payments
Daily settlement End of period settlement
 Terminology
• Spot Price
• Futures Price
• Contract cycle
• Expiry date
• Contract size
• Basis
• Cost of carry
 Clearing and Settlement
• National Securities Clearing Corporation
Limited (NSCCL)
– Parallel Risk Management System (PRISM)
– Standard Portfolio Analysis of Risk (SPAN(r))
• SPAN
– 99% VaR methodology
• 1 day vs 2 day
– For each clearing member
 Margins
• Initial Margin
– SPAN + Exposure
• 3% for Index, max (5%, 1.5*volatility) for stocks
• Maintenance Margin
• Marking to Market
• Margin Call
 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

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 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$1250
– 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)

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A Possible Outcome

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Margin Cash Flows When Futures Price
Increases

Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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Margin Cash Flows When Futures Price
Decreases
Clearing House

Clearing House Clearing House

Member Member

Broker Broker

Long Trader Short Trader

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 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
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 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

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 Short Selling

• Short selling involves selling securities you do not own

• Your broker borrows the securities from another client and
sells them in the market in the usual way
• At some stage you must buy the securities so they can be
replaced in the account of the client
• You must pay dividends and other benefits the owner of the
securities receives
• There may be a small fee for borrowing the securities

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Consumption vs Investment Assets
• Investment assets are assets held by
significant numbers of people purely for
investment purposes (Examples: gold,
silver)
• Consumption assets are assets held
primarily for consumption (Examples:
copper, oil)

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 Pricing Assumptions
• No transaction costs
• Same tax rate on profits
• Risk free rate borrowing and lending
• Arbitrage is possible
Notation for Valuing Futures and
Forward Contracts

S0: Spot price today

F0: Futures or forward price today
T: Time until delivery date
r: Risk-free interest rate for
maturity T

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 Forwards Valuation

Situation Formula
Investment Asset Known Income F0 = (S0 – I )erT
Investment Asset Known Yield F0 = S0 e(r–q )T
Value of Long Forward @ K (F0 – K )e–rT
Stock Index F0 = S0 e(r–q )T
Currency, r local, rf foreign F0 = S0 e(r–rf)T
Consumption Asset, storage per unit time F0  S0 e(r+u )T
Consumption Asset, storage F0  (S0+U )erT
Consumption Asset, Yield, c=r+u-y F0 = S0 ecT
 Forward vs Futures Prices

• When the maturity and asset price are the same, forward and
futures prices are usually assumed to be equal.
• When interest rates are uncertain they are, in theory, slightly
different:
– A strong positive correlation between interest rates and the asset price
implies the futures price is slightly higher than the forward price
– A strong negative correlation implies the reverse

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 Long & Short Hedges

• A long futures hedge is appropriate when you

know you will purchase an asset in the future
and want to lock in the price
• A short futures hedge is appropriate when you
know you will sell an asset in the future and
want to lock in the price

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 Arguments in Favor of Hedging
• Companies should focus on the main business
they are in and take steps to minimize risks
arising from interest rates, exchange rates, and
other market variables
Arguments against Hedging
• Shareholders are usually well diversified and can
make their own hedging decisions
• It may increase risk to hedge when competitors do
not
• Explaining a situation where there is a loss on the
hedge and a gain on the underlying can be difficult

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 Basis Risk
• Basis is usually defined as the spot price minus the
futures price
• Basis risk arises because of the uncertainty about the
basis when the hedge is closed out before maturity
• Define
F1 : Futures price at time hedge is set up
F2 : Futures price at time asset is Purchased / Sold
S2 : Asset price at time of Purchase / Sale
b2 : Basis at time of Purchase / Sale
Long Hedge Short Hedge
Asset price paid S2 Asset price received S2
Gain on Futures F2 −F1 Gain on Futures F1 −F2
Net amount paid S2 − (F2 −F1) =F1 + b2 Net amount received S2 + (F1 −F2) =F1 + b2
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 Choice of Contract
• Choose a delivery month that is as close as
possible to, but later than, the end of the life
of the hedge
• When there is no futures contract on the asset
being hedged, choose the contract whose
futures price is most highly correlated with
the asset price. This is known as cross
hedging.

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 Optimal Hedge Ratio

Proportion of the exposure that should optimally be

hedged is
s
h*  r S
where sF
sS is the standard deviation of DS, the change in the spot
price during the hedging period,
sF is the standard deviation of DF, the change in the futures
price during the hedging period
r is the coefficient of correlation between DS and DF.

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 Optimal Number of Contracts

QA Size of position being hedged (units)

QF Size of one futures contract (units)
VA Value of position being hedged (=spot price time QA)
VF Value of one futures contract (=futures price times QF)

Optimal number of contracts

Optimal number of contracts if after tailing adjustment to allow
no tailing adjustment for daily settlement of futures

h *Q A h *V A
 
QF VF

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 Example (Page 70)
• Airline will purchase 2 million gallons of jet
fuel in one month and hedges using heating
oil futures
• From historical data sF =0.0313, sS =0.0263,
and r= 0.928
0.0263
h  0.928 
*
 0.7777
0.0313

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 Example continued
• The size of one heating oil contract is 42,000 gallons
• The spot price is 1.94 and the futures price is 1.99 (both
dollars per gallon) so that
V A  1.94  2,000,000  3,880,000
V F  1.99  42,000  83,580
• Optimal number of contracts assuming no daily
settlement
 0.7777  2,000,000 42,000  37.03
• Optimal number of contracts after tailing
 0.7777  3,880,000 83,580  36.10

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 Hedging Using Index Futures
To completely hedge the systematic risk in a portfolio, the number of
contracts that should be shorted is VA
b
VF
where VA is the value of the portfolio, b is its beta, and VF is the value of
one futures contract

S&P 500 futures price is 1,000, Value of Portfolio is $5 million

Beta of portfolio is 1.5.
• What position in futures contracts on the S&P 500 is necessary to hedge the
portfolio?
• What position is necessary to reduce the beta of the portfolio to 0.75?
• What position is necessary to increase the beta of the portfolio to 2.0?

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 Why Hedge Equity Returns
• Maybe manager want to be out of the market
for a while. Hedging avoids the costs of selling
and repurchasing the portfolio
• Suppose stocks in your portfolio have an
average beta of 1.0, but you feel they have
been chosen well and will outperform the
market in both good and bad times. Hedging
ensures that the return you earn is the risk-
free return plus the excess return of your
portfolio over the market.

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 Example
• Value of S&P500 Index = 1000
• S&P500 futures price = 1010
• Value of Portfolio = $5,050,000
• Risk free rate = 4% p.a.
• Dividend yield on Index = 1% p.a.
• Beta of portfolio = 1.5
• Lot size of futures = 250

• What is the number of contracts to be shorted to completely hedge the

portfolio ?
• What is the value of the portfolio in 3 mths under the following scenarios
Index 900 950 1000 1050 1100
Futures 902 952 1003 1053 1103
 Stack and Roll
• We can roll futures contracts forward to
hedge future exposures

• Initially we enter into futures contracts to

hedge exposures up to a time horizon

• Just before maturity we close them out an

replace them with new contract reflect the
new exposure

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 Liquidity Issues
• In any hedging situation there is a danger that
losses will be realized on the hedge while the gains
on the underlying exposure are unrealized

• This can create liquidity problems

• One example is Metallgesellschaft which sold long

term fixed-price contracts on heating oil and
gasoline and hedged using stack and roll

• The price of oil fell.....

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