Forwards and Futures Flashcards
(26 cards)
Forward contract
a commitment to purchase at a future date a given amount of a commodity or an asset at a price agreed today.
Long forward: bought a forward contract, so this party has agreed to buy the underlying asset, and has what is termed a long position.
Short forward: sell a forward contract, so this party has agreed to sell the underlying asset at an agreed price, and has what is termed a short position.
Spot markets
buy/sell assets for immediate delivery, pay current market price (S0). ◦ If we need an asset in the future (T), if trading in the spot market, we buy it at that future date and pay the spot price at that time (ST). Face price uncertainty-today we do not know what the future spot price will be
Forward/Futures markets
agree now to trade an asset for future delivery, e.g. 6
months’ time. Agree the price today (F0), but this price will be paid in 6 months time
when the trade actually takes place. Eliminates price uncertainty.
Trading in forward contract
is done through networks of dealers and intermediaries on OTC markets. Contracts are all different; delivery time, place, type of rice…
Contracts are bilateral-terms are negotiated directly between the buyer and seller.
No organised exchanges and no exchange-issued standard contracts
Contracts are customizable and tailored to the needs of the two parties (nonstandard)
Contracts differ in liquidity
Forwards are less liquid than futures
No money changes hands until maturity
Non-trivial counterparty risk
Parties are prevented from defaulting by
loss of reputation & loss of future trading opportunities.
Commodity forward contracts
users of the commodity wish to hedge against rising spot prices. Suppliers of the commodity wish to hedge against falling spot prices.
Default risk
there’s no guarantee against default risk (credit risk exposure). Large reputable companies trade in forwards.
Advantages of the long hedge using forwards -
Purchase price is locked in
A forward contract has no initial cash outlay
Forward contract vs. buying now
Buying the asset entails costs of carry
extra cost of buying and holding a commodity, including interest payment, opportunity cost, insurance and storage.
Default risk is limited to ST – F0
Transactions costs may be lower in forwards than in spot trading
Disadvantages of the long hedge -
The spot price may fall
Default risk is present
The firm must be large and have a good reputation
Two sets of transactions costs may be incurred
Trading forward
Trading at spot if the forward contract is not settled by delivery
Forward contracts have 3 main limitations -
Country party risk
What if the price of soybeans falls? the Tofu manufacturer (long position) may decide to buy the soybeans from elsewhere because it’s cheaper
What if the price of soybeans goes up? The warehouse (short position) may renege
Default risk: The most serious risk is that you may end up without materials for your production/manufacturing.
Non-standardised
Illiquidity
Futures market
A futures contract is an exchange-traded, standardized, forwardlike contract that is marked to market daily. This contract can be used to establish a long (or short) position in the underlying asset. Like the forward, still a contract where committing to buy/sell at a future date a given amount of a commodity or an asset at a price agreed today.
Spot vs forward/future markets
The future price is always higher than spot price, why? storage and other costs makes entering a long forward/futures position more attractive/convenient, and therefore more valuable.
Spot market: assets are traded for delivery now.
Forward/futures market: agree now to make purchases in the future.
Future contract
are less flexible than forward contracts but are much more liquid and are default protected. Same type of agreement as a forward contract but:
Standardised Contracts, issued by an Exchange
Guaranteed by the Clearing House of the Exchange (no default risk)
Highly liquid, because high-volume secondary markets exist
Cash flows occur throughout the life of the contract, through daily re-settlement
Forwards-no cash flow before delivery
Either party can close their position at any time before maturity.
Role of the exchange
Regulate trading
Specify contract details
Set daily settlement prices
Establish the clearing house
Role of the clearing house
guarantees the futures contract to end-users
requires brokers to open margin accounts
makes margin calls against brokers
matches and records all trading records each day
announces the daily settlement price
sets daily price limits
arranges conditions for delivery of contracts
supervises the operation of the market
Position (number of contracts) limits
prevents excessive speculation by individuals.
Price limits
set to prevent large price changes due to speculative excesses. Ensures that the clearing house does not incur large credit risks. Trading ceases for the day or is temporarily suspended if prices move beyond set limits. Prevents large changes in price from destabilising the market.
Contract size
This specifies the amount of the underlying asset that will be delivered in one contract.
Delivery months
Contracts are referred to by their delivery month (contract expires, time T). The exchange specifies the time during the delivery month when the delivery will take place. But the delivery period could be the whole month. Delivery months vary contract to contract.
Margin and trading arrangements
Initial margin: funds or interest-earning securities deposited to provide capital to absorb losses.
A margin account must hold a min reserve. The account is reduced by losses and increased by profits.
Maintenance margin: level at which the account must be replenished, or position reduced.
A variation margin: the amount required to restore min balance
Margin call: - when the maintenance margin is reached, the broker will ask for additional margin funds. A margin call must be met within a very short time (anytime from one or two days to as little as an hour).
Obligations
the short has an obligation to deliver, long position has an obligation to buy. The clearing house acts as guarantor to end-users, protecting against default by either brokers or clients.
End-users have margin accounts with brokers.
Brokers have accounts with the Clearing House.
The amount of the margin that is required depends on
Type of contract and underlying asset
Size of the contract and the rep of the customer.
Key feature of margins
Margin required as collateral to cover losses
Gains/losses settled daily (marked to market)
Guaranteed by the clearing house
Counterparty risk is thus eliminated
You don’t even know who is your counterparty (no need)
The future prices are pure prices, and do not contain information about counterparty risk
Daily settlement
Prevents the accumulation of losses and therefore lowers the probability of end-user default; reduces credit risk. Hence, allows the clearing house to guarantee the futures contract.
The difference between the day’s opening and closing prices is the day’s profit or loss.
There is a cash flow out of the margin account of the short position into the account of the long position.
The value of the futures contract is re-set to zero, because each day profit/losses are settled.
The futures price in the contract is re-set at the day’s settlement price.
Marked to market
in theory, the buyer and seller of a forward contract can decide to settle the contract every day since day 1. One party will pay the other the difference daily, forming a new contract; mark to market.
Counterparty risk is eliminated.
The money that went back and forth would equal the same as a forward contract held to maturity.
Future contracts can be thought of as a sequence of forward contracts.
Note - if the amount in the margin account falls below the maintenance margin (200), the long receives a margin call. She’s required to top-up her margin account to the initial level by the next day; that’s called the variation margin. If the investor fails to provide the variation margin the broker closes the position.
