Chapter 2:

Forwards and futures

2.1 Forwards
2.1.1 Mechanics of forwards
2.1.2 Hedging strategies with forwards
2.2 Futures
2.2.1 Mechanics of futures
2.2.2 Hedging strategies with futures

1
2.1 Forwards
2.1.1 Mechanics of forwards

► Definition
A forward contract is an agreement between two parties to buy or sell
an underlying asset for a certain price (for a specified quantity),
payment and delivery postponed at a later date into the future

→ buying a forward contract (taking a long position on a forward)

means committing to buy an asset for a certain price, payment
and delivery postponed at a later date into the future

→ selling a forward contract (taking a short position on a forward)

means committing to sell an asset for a certain price, payment and
delivery postponed at a later date into the future

• Most popular forwards are foreign exchange forwards : the

underlying asset is a foreign currency 2
► Market : forwards are traded on OTC markets, decentralized
markets where market participants are free to negotiate any
mutually attractive deal (traded contracts are not standardized)
This is a quote-driven market, a network of dealers or market
makers always prepared to quote a bid price (a price at which
they are prepared to buy) and an offer price/ask (a price at which
they are prepared to sell)

► Application : table of quotes given by a bank acting as a market

maker on 5th Feb year N for spot and forward contracts for
underlying asset EUR (prices in USD)
Bid Ask
Price for which the bank is Price for which the bank
ready to buy one EUR is ready to sell one EUR
Spot 1,4035 1,4040
1-month forward 1,3965 1,4015
3-months forward 1,3925 1,3965
6-months forward 1,3834 1,3875
3
1-year forward 1,3756 1,3795
►Meaning of taking a position on the spot contract :

→ buying a spot contract (taking a long position on the spot contract) means
committing to buy one EUR (the underlying) for the price of 1,4040 USD (ask) for
immediate delivery and payment.

→ selling a spot contract (taking a short position on the spot contract) means
committing to sell one EUR (the underlying) for the price of 1,4035USD (bid) for
immediate delivery and payment.

► Meaning of taking a position on forward contracts : case of 6 months forward :

→ buying a 6-months forward (long on the 6-months forward) means

committing to buy one EUR (the underlying) for the price of 1,3875 USD (ask) for
delivery and payment in 6 months.

→ selling a 6-months forward (short on the 6-months forward) means

committing to sell one EUR (the underlying) for the price of 1,3834 USD (bid) for
delivery and payment in 6 months.

4
2.1.2 Hedging strategies with forwards

► Application 1:
on Feb 5th N a US company owes a payable of 1 million EUR to be paid in 6
months on 5th Aug N;  −1
→ EUR is the underlying asset source of market risk : risk profile  +1
→ the company is risk averse, it would like to get rid of risk: it would like to be
able to lock in NOW (Feb 5) the price for which it will buy 1 million EUR in
6 months (Aug 5); is it possible?
→ yes this is possible by taking a long position on a forward 6 months for 1
million EUR at 1,3875 USD (ask) : committing to buy 1 million EUR for
1,3875 USD for one EUR, payment and delivery to take place on Aug 5
→ risk profile becomes :
 −1  +1  0 
 +1 +  −1 =  0 
     

Initial risk profile final risk profile

after hedging
Risk profile on long forward
5
► Application 2:
on Feb 5th N a US company has a receivable of 1 million EUR to be paid in 6
months on 5th Aug N;  +1
→ EUR is the underlying asset source of market risk : risk profile  −1
→ the company is risk averse, it would like to get rid of risk: it would like to be
able to lock in NOW (Feb 5) the price for which it will sell 1 million EUR in
6 months (Aug 5); is it possible?
→ yes this is possible by taking a short position on a forward 6 months for 1
million EUR at 1,3834 USD (bid) : committing to sell 1 million EUR for
1,3834 USD for one EUR, payment and delivery to take place on Aug 5
→ risk profile becomes :
 +1  −1 0 
 −1 +  +1 = 0 
     

final risk profile

Initial risk profile after hedging
Risk profile on short forward

6
2.2 Futures

2.2.1 Mechanics of futures

► Definition

■ Like a forward, a futures contract is an agreement between two parties to buy or

sell an underlying asset for a certain price (for a specified quantity), payment and
delivery postponed at a later date into the future
→ buying a futures contract (taking a long position on a future) means committing
to buy an asset for a certain price, payment and delivery postponed at a later date
into the future
→ selling a futures contract (taking a short position on a future) means committing
to sell an asset for a certain price, payment and delivery postponed at a later date
into the future

► Markets and trading

■ Unlike forwards, futures are traded on an exchange between two parties, an
organized and centralized market where buyers and sellers (who will not know
each other) trade standardized contracts defined by the exchange
This is an order-driven market that centralizes all buy orders and sell orders for
the contracts, and lists them in the order book to find out matches 7
■ Standardization : unlike the forwards, all features of the futures contract are
standardized (precisely defined by the exchange)
→ asset definition is standardized : wide range of commodities or financial assets
→ contract size is standardized : amount of the asset that has to be delivered under
one contract
→ delivery month (maturity) is standardized
→ delivery arrangements are standardized : place of delivery, time of delivery…

■ Transaction : once a match is found out between a buy order and a sell order a
transaction takes place for the matching price and that price is quoted for the
contract:
→ the price of the futures is always the price per unit of underlying asset
→ the buyer opens a long position on the number of contracts traded (n)
→ the seller opens a short position on the number of contracts traded (n)
→ the volume of transaction is increased by n
→ the open interest moves according to the number of outstanding contracts

■ Unlike the forwards, any opened position can be closed out at any time before
the maturity of the futures by taking an opposite position (but of course this
may occur for a different price)
→ long position closed by taking a short position on the same contract
8
→ short position closed by taking a long position on the same contract
 ■ Evolution of contract prices to the maturity/delivery month
→ before its maturity the price of a futures changes according to the law of supply
and demand
→ before maturity the price of the contract (which is always quoted per unit of
underlying asset) may be different from the spot price of the underlying asset

→ at its maturity the price of the futures is equal to the spot price of the
underlying asset
- if futures price > spot price at maturity, buying the asset spot and selling the
futures would bring a riskless profit
- if futures price < spot price at maturity, buying the futures and selling the asset
spot would bring a riskless profit
Futures price
Spot price

Spot price
Futures price

(a) (b)
time time
Source : Hull, chap 2 Maturity date of the future 9
Maturity date of the future
■ patterns of futures price with respect to maturity/delivery time

→ when the futures price is an increasing function of the maturity of the

contract : contango

example : when we observe for the Gold future that the farther the maturity the
higher the future price, we have a situation called “contango” on the Gold
future

→ when the futures price is an decreasing function of the maturity of the

contract : backwardation

example : when we observe for the Oil future that the farther the maturity the
lower the future price, we have a situation called “backwardation” on the Oil
future

10
► the operations of margins
Unlike forwards, futures contract are without any credit risk because the exchange
via its clearing house offers a setting that gets rid of it : the operations of margins

■ Initial deposit in the margin account

→ once a transaction is carried out each party opening a position (the long one and
the short one) on a futures contract must deposit funds in a margin account : the
initial deposit
→ the initial deposit depends on the volatility of the contract price : 1-10% of total
amount of the position
total amount of position = futures price × contract size × number of contracts traded

■ daily settlement or daily marking to market

→ At the end of each trading day, the margin account is adjusted to reflect the
investor’s daily gain or loss by doing as if the position were closed at the
settlement price (prior settle)

→ For a long position margin account balance adjusted with respect to:
(settlement price - future price) × contract size × number of contracts traded

→ For a short position margin account balance adjusted with respect to :

(future price - settlement price) × contract size × number of contracts traded
11
Example :
→ Transaction carried out on day 1 (June 5th) between a buyer and a seller for 2
futures gold December at 1250 USD per ounce (contract size = 100 ounces)
→ On day 1 opening of the margin account for both the buyer and the seller
Margin account set at 4,8% : Initial deposit =4,8%×(1250×100×2)=12000 USD
→ At the end of the day, first daily marking to market taking place (settlement
price = 1241 USD )
for the long position marking to market : (1241 - 1250) ×100×2 = -1800 USD
for the short position marking to market : (1250 - 1241) ×100×2 = +1800 USD

■ Maintenance margin and margin calls

Minimum balance in the margin account (70-80% of initial deposit)
• if margin account balance < maintenance margin : margin call
• investor expected to top up the margin account to the initial deposit level
• Otherwise the broker closes out the position
Example :
→ maintenance margin set at 75% : 75% × 12000 = 9000 USD
→ at the end of day 6 prior settle is 1236,20 and margin account balance is 9240
→ if at the end of day 7 prior settle is 1229,90 daily marking to market leads for
the long position to adjustment = (1229,90 – 1236,20) ×100×2 = -1260 USD
and the balance is then 9240 -1260 = 7980 USD < 9000
12
→ at the end of day 7, margin call = 12000 – 7980 = +4020 USD
 Decides
to buy 2
contracts

Decides to
close out
the position Source : Hull, chap 2 13
2.2.2 Hedging strategies with futures

► short hedge or lock in the price NOW for selling an asset in the future
A short hedge is a hedge that involves a short position in futures contracts.
A short hedge is appropriate :
→ when the hedger already owns an asset and expects to sell it at some time in the
future (a farmer who knows next wheat harvest will be ready for sale at the local
market in two months)
→ when an asset is not owned yet but will be owned at some time in the future (a
US exporter who knows NOW that he will receive euros in 3 months)

► long hedge or lock in the price NOW for buying an asset in the future
A long hedge is a hedge that involves a long position in futures contracts.
A long hedge is appropriate :
→ when a company knows it will have to purchase a certain asset in the future and
wants to lock in a price NOW :
a copper fabricator knows NOW it will need 100000 pounds of copper in 3 months
a US importer who knows NOW that he will have to pay euros in 3 months 14
► hedging by using futures for making delivery or taking delivery (rare)
P1 price of futures at time 1 (time of hedging)

→ long hedge:
• At time 1, buying the future for P1
• At time T / delivery month, taking delivery and making the payment (according
to delivery arrangements rules set by the exchange)
Payoff time T/delivery month = - P1 (×contract size ×number of contracts traded)

→ short hedge:
• At time 1, selling the future for P1
• At time T / delivery month, making delivery and receiving payment (according to
delivery arrangements rules set by the exchange)
Payoff time T/delivery month = + P1 (×contract size ×number of contracts traded)

→ Notice : making / taking delivery can be costly and inconvenient : delivery is not
usually made. Hedgers usually avoid any possibility of having to take delivery or
make delivery by closing out their positions before the delivery period. 15
► hedging by using futures as a financial instrument (usual way)
P1 price of futures at time 1 (time of hedging)
PT price of futures at time T/delivery month (= spot price of underlying asset)
→ long hedge:
• At time 1, buying the future at P1
• At time T, in delivery month, closing the position by selling the future at PT
• At time T, buying the asset spot
payoff from futures market = PT - P1 (×contract size ×number of contracts traded)
payoff from buying the asset spot = - PT (×total quantity traded)
Total payoff = (PT - P1) + (- PT) = - P1 (×contract size ×number of contracts traded)

→ short hedge:
• At time 1, selling the future at P1
• At time T, in delivery month, closing the position by buying the future at PT
• At time T, selling the asset spot
payoff from futures market = P1 - PT (×contract size ×number of contracts traded)
payoff from buying the asset spot = + PT (×total quantity traded)
16
Total payoff = (P1 - PT) + (PT) = + P1 (×contract size ×number of contracts traded)
► Application to commodity futures
On October 14th in year N a company knows that it will have to buy 15000 oil
barrels in March N+1. On 14/10/N in CME oil future March N+1 quotes 87.69.
The company is risk averse, it would like to lock in on Oct 14 the price for which it
will buy 15000 oil barrels in March N+1
→ Long hedge by using futures for taking delivery :
• On October 14th taking a long position on 15 oil futures March N+1 at P1=
87.69 and holding the long position up to delivery month.
• in March N+1 (delivery month) taking delivery of 1000×15 oil barrels
according to CME delivery rules : payoff = -87.69×1000×15 = -1 315 350 USD
→ Long hedge by using futures as financial instruments :
• on October 14th taking a long position on 15 futures March N+1 at P1= 87.69
• in March N+1 (delivery month)
- closing out the position for PT = futures price at delivery date = spot price of oil
barrel = 110 USD :
Payoff futures trade = (110 - 87.69) ×1000×15 = +334 650 USD
- buying spot 15000 oil barrels at 110 USD :
payoff spot trade = -110×15000 = - 1 650 000 USD
Total payoff = (+334 650 ) + (- 1 650 000 ) = -1 315 350 USD
or – 1315350/15000 = -87.69 USD per barrel 17
►Application to forex futures
On October 14th in year N a US company knows that it will receive 500000 EUR in
March N+1. On Oct 14th in CME EUR-USD futures March N+1 quotes 1,2548
(futures size = 125000 EUR)
The company is risk averse, it would like to lock in on Oct 14 the price for which it
will sell 500000 EUR in March N+1

→ short hedge by using futures as financial instruments :

• on October 14th taking a short position on 4 futures March N+1 at P1= 1,2548
• In March N+1 (delivery month)
- Closing out the position for PT = futures price = spot price of EUR-USD = 1,1015
USD
Payoff futures trade = (1,2548 – 1,1015) ×125000×4 = +76650 USD
- selling spot 500000 EUR for 1,1015 :
Payoff spot trade = +1,1015×500000 = + 550 750 USD

Total payoff = (+76650 ) + (+550750 ) = +627400 USD

or + 627400/500000 = +1,2548 USD per EUR

18