__Forward: an agreement between 2 parties that is initiated at one point in time, but requires the parties to the agreement

to perform, in accordance with the terms of the agreement, at some future point in time. __Seller / Holder of the Short Position: Party obliged to Deliver the Stated Asset __Buyer / Holder of the Long Position: Party obliged to Pay for the Stated Asset __Deliverable Item/ Underlying Asset: asset to be traded under the terms of the contract __Settlement / Maturity / Expiration: Time at which the contract is to be fulfilled by the trading of the underlying asset. __Contract Size: Quantity of the underlying asset that is to be traded at the time the contract settles __Invoice Amount / Forward Contract Price: Amount that must be paid for the contract size of the underlying asset by the holder of the long position at the time of the settlement __Forward Contracts are NOT Investments; they are simply agreements to engage in a trade at a future time and at a fixed price. Thus, it costs NOTHING to enter into such a contract; Since nothing is Bought or Sold, contracts are Entered Into or Sold Out. There are THREE ways to Close Out (Settle) a contract __Enter an Offsetting Transaction: __Making/Taking Physical Delivery of the underlying commodity under the terms & conditions specified by the contract: __Cash Settlement __Over-the-Counter Forward Contracts are Flexible, but 3 major disadvantage __ILLIQUID: designed for specific needs __CREDIT RISK: No collateral or marked to marketing, rather it is just trust __UNREGULATED: no formal body regulates the players in the market

B. FUTURES CONTRACTS
__Futures: special forms of forward contracts that are designed to reduce the disadvantages associated with forward agreements. Indeed, they are Forwards whose terms have been STANDARDIZED to that they can be traded in a public marketplace. Less Flexible, but more liquid. __Usually traded on FUTURES exchanges, who establish terms of standardization, rules or Pit trading, daily price limit, trading hours, and settlement price methods. __Regulated by the CFTC. __Brokers: Account Executives who take orders from customers and relay them to the floor; and Floor Brokers who operate on the floor and execute orders for others and for themselves. __CLEARINGHOUSE: interposed between each side and guarantees the contract. __POSTING MARGIN, MARKING TO MARKET __Capital Gains are based upon the NET DAILY SETTLEMENT gains or losses that occur in a tax period, rather than upon the net gains or losses that result form contracts that are closed out during a tax period. __FUTURES is a ZERO sum GAME

C. RELATIVE CREDIT RISKS IN FORWARD v. FUTURES CONTRACS

__To ease Credit Risk in the Futures Market, there are 3 types of protections built-in, as opposed to a mere Forward Contract __Daily Settlement: Unrealized Gains/Losses must be settled with cash on a Daily Basis (by way of Margin Calls & Account Crediting/Debiting between Clearinghouse & Regular Accounts) __Margin: Accounts must maintain sufficient balances in their accounts so as to be able to cover several days worth of potential mark-to-market transfers. __Clearinghouse: Guarantees the transactions & insures settlement of the daily mark-to-market gains & losses

D. USES OF FUTURES & FORWARDS

1. Speculation __Ratio of the Profit to the amount of funds that were potentially at risk, rather than the ratio of the profit to the cash that was put up on margin is the correct way to measure the return on investment __Advantages of Using Futures/Forwards for Speculative Purposes: __Lower Transaction Costs and better Liquidity __No need for Storage or Insurance __Can Sell Short in the Futures/Forwards, which may not be possible in the Spot Market __Employs a great deal of leverage __Disadvantages of Using Futures/Forwards for Speculative Purposes: __With lots of Leverage, Huge Losses could be incurred __Margin Calls means that there is a need (potentially) to have lots of free cash 2. Hedging __2 Types of Hedges: the Long Hedge where the Hedger takes a long position & the Short Hedge where the Hedger takes a Short Position __Long Hedges: are used when One is EXPECTING to Acquire an asset in the future, but there is concern that its price might rise in the meantime. To alleviate this price risk, the Hedger takes a long position in the futures contract and then if the price does rise, his profit on the Hedge can be used to offset the higher cost of purchasing the commodity. The same principal applies if the price falls. Either way, the net price paid for the commodity in the future can be fixed in the present. __Short Hedges: Used to reduce risk associated with possible changes in the price of OWNED Assets. Same Principals. __Difficulties encountered when using Futures as Hedges __TO succeed, need to understand complex relationships __Might not work if Futures are MISPRICED __Hedging Profits generate Tax consequences because the daily settlement cash inflows from unrealized financial gains/losses on futures used as hedges are taxable, even though the offsetting loss incurred in the value of the commodity held long is NOT tax deductible until realized 3. Arbitrage __Arbitrage is an opportunity to make a risk-less profit without having to make any net investment. There is a no Arbitrage principle in Financial Theory. __However, market imperfections allow for some arbitrage opportunities. SOCIAL PURPOSES of Futures: __Risk Shifting from Hedgers to Speculators __Price Discovery

E. TYPES & CHARACTERISTICS OF FUTURES CONTRACTS

COMMODITY FUTURES Position Held to Settlement Gain on Long = Loss on Short = K-Size * (Ss F0) Position NOT Held to Settlement Gain on Long = Loss on Short = K-Size * (Ft F0) Daily Settlements Gain on Long = Loss on Short = K-Size * (Ft Ft-1) STOCK INDEX FUTURES __Stock Index Futures are Settled in Cash, rather than Physical Delivery __Index Multipliers: S&P _ 500, NYSE _ 500, MMI _ 500, NIKKEI _ 5 Position Held to Settlement Gain on Long = Loss on Short = Multiplier * (Ss F0) Position NOT Held to Settlement Gain on Long = Loss on Short = Multiplier * (Ft F0) Daily Settlements Gain on Long = Loss on Short = Multiplier* (Ft Ft-1) TREASURY BOND FUTURES __Settled with the Physical Delivery of Treasury Bonds. To satisfy, the holder of the short must deliver 100 Treasury Bonds ($100,000 par value) that mature in (or cant be called for) at least 15 years

__Since many Treasury Bonds could possibly be delivered, require a Conversion for Quotes on the Deliverable Bond Invoice PriceDB = (F0 * Conversion FactorDB) + Accrued InterestDB
Position Held to Settlement Gain on Long = Loss on Short = $1,000 * (F s - F0) * Conversion FactorDB Position NOT Held to Settlement Gain on Long = Loss on Short = $1,000 * (F t F0) Daily Settlements Gain on Long = Loss on Short = $1,000 * (F t Ft-1)

TREASURY BILL & EURODOLLAR FUTURES __TREASURY BILL: require the holder of the short to deliver $1,000,000 face value of treasury bills that mature 3 months from the delivery date. A T-bill future (IMM index) is stated as: F0 = IMM Index = 100 R0 : R0 is the Annualized Discount Rate; i.e., 100 95 = 5 Invoice Price(%) = 100 [R0tm/360] __If the quoted price is 95, that does NOT mean that when 1,000,000 face value of 3 month treasury bills are delivered at the time of settlement the invoice price to be paid is $950,000. Rather, the Quotation of 95 means that the contracted price to be paid on settlement day is a price that will correspond to an ANNUALIZED discount of 5% at that time. Will be 98./75. __1 Basis Point (.01) change in the IMM Index for 90 day treasury bills = $25 change in its dollar value. __EURODOLLAR: similar to treasury bills, but different. R0 * = [R0/Price][360/tm] Invoice Price (%) = 100 [R0 *tm/360] For Both Treasury Bill & Eurodollar Futures
Position Held to Settlement Gain on Long = Loss on Short = $2,500 * (Ss F0) Position NOT Held to Settlement Gain on Long = Loss on Short = $2,500 * (F t F0) Daily Settlements Gain on Long = Loss on Short = $2,500 * (F t Ft-1)

CURRENCY FUTURES __Most Currency Trading takes place between banks. But, there are speculative opportunities
Position Held to Settlement Gain on Long = Loss on Short = Contract Size X/Y * (SX/Y s FX/Y 0) Position NOT Held to Settlement Gain on Long = Loss on Short = Contract Size X/Y * (FX/Y t FX/Y 0) Daily Settlements Gain on Long = Loss on Short = Contract Size X/Y * (FX/Y t FX/Y t-1)

F. VALUING FORWARD & FUTURES CONTRACTS

__Forwards & Futures are NOT investable Assets. Rather, they are agreements that are valued by an arbitrage pricing model called the spot-futures parity theorem or the cost-of-carry relationship F0 = S0 * [1 + (rftm/360) + CP - IP F0 is the Futures Contract Price S0 is the Spot Price of the Underlying Asset rf is the Risk Free Rate tM is the number of days til the contract Matures CP is the cost of Storing Insuring the Underlying asset over the life of the contract IP is the income generated by the underlying asset over the life of the contract in the form of interest or dividends, plus any interest that can be earned on such payments from the time they are received until the contract expires rf is the risk free rate, and if the spot & futures markets are mispriced, it is the IMPLIED REPO rate, which is the rate that will be earned risk free by the arbitrageur __Basis is the spread between the spot price of an underlying commodity and the price of a futures contract on the commodity. Basis = S0 F0 __Convergence; on settlement day, the price of a futures contract will equal the price of the underlying commodity in the spot market (the basis will be zero). Fs = Ss __Calendar Spread is the difference in price between 2 futures contracts that have the same underlying commodity, but 2 different settlement dates. F0 Distant = F0 Near [ 1 + rf*((tm distant tm near)/360)]

__If the prices of Nearby Contracts are Higher than those of Distant Contracts, the futures market is said to be INVERTED Valuing Stock Index Futures Contracts __Valued according to the Spot-futures Parity Theorem. But the Cost of Storing & Insuring is Negligible. F0 = S0 * [ 1 + (rftM/360) DP] __Stock Index Arbitrage is Effectuated through Program Trading. Valuing Treasury Bond Futures Contracts __Also uses the Spot-Futures Parity Theorem, but there are some unique features. For example, several bonds can satisfy the delivery requirements. But there is the conversion factor. __Instead, it is a 2 Step Process: Determine the INVOICE PRICE of a Deliverable Bond & then get the FUTURE Price of the MOST Deliverable Bond (the Cheapest Bond with the HIGHEST YTM) Invoice PriceDB = SDB * [1+ (rftm/360)] - IDB F0 = (Invoice PriceDB / Conversion FactorDB) __Contract Price of a Treasury Bond Futures is Based upon the Spot Price and the Conversion Factor of THE Most Deliverable Treasury Bond in the Market Valuing T-Bill & Eurodollar Futures Contracts __Also uses the Spot-Futures Parity Theorem to value, but the contracts are QUOTED as 100 Annualized discount rate at which they are priced. It is a Multi-step Process. 1. Determine the Invoice Price to be paid for a 3 month treasury bill, or euro, when the contract matures. Invoice Price = S0 * [ 1 + (rftm/360)] 2. Determine the Dollar Discount Rate DF = 100 Invoice Price 3. Annualize the Dollar Discount rate to Obtain the Annualized Discount Rate that corresponds to the Invoice Price of the 3 month Treasury at the time of Settlement. F0 = 100 [(360/90)*Df] Maturity of T-Bill Underlying a T-Bill Future = Maturity of Contract + 3 Months
Implied Repo Rate = [(Invoice Price of Contract / Spot Price of T-Bill Underlying the Contract) * (360/tm)

__Arbitrage Opportunities Exit if the Implied Repo Rate is different from the borrowing rate or risk free rates

Valuing Currency Futures Contracts FY/X = SY/X [ (1+ rY Periodic) / (1 + rX Periodic)] FX/Y = SX/Y [ (1+ rX Periodic) / (1 + rY Periodic)] Covered Interest Arbitrage __Interest rate parity defines the relationship between the value of a forward currency exchange rate and the spot exchange rate because it is a no-arbitrage Solution. If Interest rate parity does not hold, an arbitraging opportunity exists. __If the Forward Market is Too Expensive, the Covered Interest Arbitrage requires the Arbitrageur to Short the Forward and buy the Spot (and vice versa)

G. HEDGING WITH FORWARD & FUTURES CONTRACTS

To Plan a Hedging Strategy, several Decisions Must be made. 1. Determine the Appropriate Hedging Vehicle __The Pricing Movements of the Hedging vehicle should closely correlate with the price movements of the commodity being hedged. __If not the same commodity, a cross-hedge may need to be employed. __Try to choose a futures contract whose contract size divides as evenly as possible into the quantity of the commodity being hedged. __Choose a futures contract that Settles CLOSE to the Hedging Horizon. __Choose a LIQUID Hedging Vehicle 2. Determine the Proper Hedge Ratio 3. Determine the Target Price that is likely to be achieved by using the hedge __May be difficult to calculate Vtarget = F0 + (SL FL) = F0 + BasisL L is the Lifting Date 4. Determine the Probable Effectiveness of the Hedge Determining the Number of Contracts Required to Perform a Total Hedge NF = - (Hedge Ratio/Contract Size)*(Quantity of the Commodity to be Hedged) Determining the Hedge Ratio Hedge Ratio = (COVC,F / F 2) = (C,FC/F) = BF Cross-hedging __When the commodity underlying the hedging vehicle is different from the commodity being hedge, the resulting hedge is a cross-hedge. __If at all possible, try to avoid using a cross-hedge because of its increased riskiness __The Higher the R2 between the cross-hedged commodities, the more effective the cross-hedge Hedging Equity Portfolios with Stock Index Futures Contracts NF = - [P / Dollar Multiplier of K * F0] * [Value of Portfolio being Hedged] NF = - [(P/(1 + rftm/360)) / Dollar Multiplier * Spot Value of Index] * [ Value of Portfolio] __In theory, the hedge should be reformulated Daily because futures contracts require that daily financial settlements be made. This is called TAILING THE HEDGE. Hedging with T-Bill Futures: ??? hope it is not on Exam Hedging with Currency Futures NF = - (Hedge Ratio / Contract Size) * (Quantity of Currency Being Hedged)