Forward and

Futures Contracts
Outline 2

1. Introduction
2. Description of forward and futures
contracts.
3. Margin Requirements and Margin Calls
4. Hedging with derivatives
5. Speculating with derivatives
6. Summary and Conclusions
Forward Contract 3

• Agreement made today between buyer

and seller
• Both are obligated to complete a
transaction at a date in the future
• Buyer and the seller know each other
• Customized agreements are negotiated
All contract terms can be customized
to the requirements of the buyer
and seller
Forward Contracts 4

• Forward Price
• Price at which the trade will occur
• Determined when the agreement made
• Default Risk
• Counterparty may have incentive to
default on the contract
• To cancel the contract, both parties
must agree
• Cancellation payment may be
required
Futures Contract 5

• Agreement made today between buyer and

seller
• Both obligated to complete a transaction at a
date in the future.
• Buyer and the seller do not know each other.
• Any "negotiation" occurs in a futures pit.
• Standardized contract terms
• What to trade; Where to trade; When to trade;
How much to trade; what quality of good to trade
—all standardized under the terms of the futures
contract.
Futures Contract 6

• Futures Price
Price at which the trade will occur
• Determined "in the pit“
• No default risk
• Futures Clearing and the exchange guarantees
each trade
• Offsetting trade "in the pit" cancels a contract
• Trader may experience a gain or a loss
Forward & Futures
Contracts 7

Both:
•Are a firm commitment by both buyer and
seller
•Specify a price today for a future
transaction
•Specify a delivery date
•Clearly define what is to be delivered and
where
•contract.
 Forward & Futures
Contracts 8
•
BUT:
• Forward contracts:
• Between a specific buyer and seller who remain linked
throughout the life of the contract
• Counterparties have negotiated an exact delivery date and terms
• Futures contracts:
• Fundamentally standardized, exchange-traded forward contracts.
• Futures contracts, on the other hand, have standardized terms –
size, delivery date, etc. They are traded on exchanges such as
the Chicago Board of Trade.
• Buyers and sellers of exchange-traded futures contracts need not
ever know each other. Everything is handled through the
exchange.
• Our focus in this chapter is on futures contracts.
Organized Futures
Exchanges 9

• Chicago Board of Trade (CBOT)Established in 1848

• Oldest organized futures exchange in US
• CME Group
• CME (1874) and CBOT merge 2007
• CME and NYMEX (1872) merge 2008
• In 2007, the Intercontinental Exchange (ICE)
purchased the New York Board of Trade (NYBOT)

• Originally all traded storable agricultural

commodities (soybeans, corn, wheat…)
Financial Futures 10

• Important milestones:
Currency futures trading 1972
• Gold futures trading
• December 31, 1974= day ownership of gold by
U.S. citizens legalized.
• U.S. Treasury bill futures
• U.S. Treasury bond futures
• Eurodollar futures
• Stock Index futures
• Today, financial futures = bulk of all futures
trading.
Futures Contract Terms 11

• Five basic terms:

• Identity and description of the underlying
commodity or financial instrument
• Contract size.
• Maturity or expiration date
• Delivery or settlement procedure
• Futures price
 Futures Price Quotes 12
• Cocoa futures
Traded on the NY Board of Trade (ICE)
• Contracts: March, May, July, September, December
• Contract Size: 10 tonnes (metric tons) = 22,046 lbs
• Price quote: $ per metric ton
• COCOA (NYBOT) – 10 metric tons $ per ton.
Recap on Marking to Market 13

• Futures contract = zero-sum

game
• Hedging and Speculation
Buyer’s gains = seller’s losses
• Futures exchanges track daily
gains/losses “Marking to market”
 Pricing of Forward Contract 14
• Suppose that Company X wants to enter into a forward
contract to buy 1,000 barrels of oil in six months. The
current spot price of oil is $60 per barrel. The risk-free
rate is 5% per annum.
• Solution
• The formula for pricing a forward contract
is:
• Forward Price=Spot Price × e^(r−c)×T
• r is the risk-free interest rate, c is the cost of carry, and T
Future Contract Price
Determination
15
For Financial derivatives
• Imagine an investor wants to enter into a
futures contract to buy 100 shares of Stock XYZ
in three months. The current spot price of Stock
XYZ is $50 per share. The risk-free interest rate
is 4% per annum, and the dividend yield on
Stock XYZ is 2% per annum. The time to
maturity for the futures contract is 0.25 years.
• Future Price =Spot Price × e^(r−q) × T
• r is the risk-free interest rate,
• q is the dividend yield, and
• T is the time to maturity in years.
Future Contract Price
Determination
16
For Commodity derivatives
Assume the current spot price (S) of gold is
$1,500 per ounce, the risk-free interest
rate (r) is 3%, and the storage cost (u) is
1%. Using the yield (y) of 2%, let's
calculate the futures price (F) for a three-
month contract (=0.25T=0.25 years):
Future Price = S×e(r+u−y)×T
•r is the risk-free interest rate,
•U is the carrying cost
•Y is the yield to hold or convenience yield
Why have marking to
market? 17

• Speculating with Futures: Long

•
Buying a futures contract:= establishing a long
position= “going long”
• Profit and Loss from a Speculative Long Position
• Every day a new futures price is established.
• If new price > previous day’s price Long position
profits
• If new price < previous day’s price, Long position
loses
 Profit and Loss from a
Speculative Long Position 18
An investor believes that the price of crude oil will increase in
the next three months. The current spot price of crude oil is
$60 per barrel. The investor decides to go long by buying one
crude oil futures contract. The futures contract has a contract
size of 1,000 barrels, and the current futures price is $62 per
barrel. The investor plans to close out the position in three
months when the futures contract expires.
Future value = No of contracts*contract size*future price
= 1*1000*62= 62000
Future Value at the time of expiry = 1*1000*65 = 65000
Gain = 65000-62000= 3000
Loss if per barrel price goes down to 60= 1*1000*60= 60000
Loss = 60000-62000= -2000
 Speculating with Futures:
Short 19
• Selling a futures contract:= establishing a short
position= “going short”
• Profit and Loss from a Short Speculative Position
• Every day before expiration, a new futures price
is established.
• If new price > previous day’s price Short
position loses
• If new price < previous day’s price Short
position profits
Operation of margins for a long position in two gold
futures
contracts of 100 each. The initial margin is $6,000 per
contract,
20
or $12,000 in total; the maintenance margin is $4,500
per
contract, or $9,000 in total. The contract is entered into
on
Day 1 at $1,250 and closed out on Day 16 at $1226.90.
 Offsetting Positions 21
• Speculating in Gold Futures
• You believe the price of gold will go down. You go
short 100 futures contracts that expire in 3
months. Futures price today = $800 per ounce.
• Gold futures contract size = 100 ounces
• Position value = $800 × 100 × 100 = $8,000,000
• If the price of gold is $770 when the futures
contract expires:
• Position value now = $770 × 100 × 100 =
$7,700,000
• Short speculation gain = $300,00
 Understanding Option
22
Contracts
• An option is a financial derivative that gives the
holder the right, but not the obligation, to buy or sell
an underlying asset at a predetermined price before
or at expiration.
• Types of Options
• Call Options
• Gives the holder the right to buy the underlying asset
at a specified price (strike price) before or at
expiration.
• Put Options
• Gives the holder the right to sell the underlying asset
at a specified price (strike price) before or at
expiration.
23
24
25
26
27
28
29
30
31
 Types of Options 32
• European Options
• Types of options that can only be exercised at
expiration, not before.
• The option holder (buyer) has to wait until the
expiration date to exercise the option.
• Commonly used in European markets for various
financial instruments.
Example:
Suppose you hold a European call option with a strike
price of $50 on Stock XYZ. You can only exercise the
option on the expiration date, regardless of the current
market conditions.
 Types of Options 33
• American Options:
• American options can be exercised at any time
before or at the expiration date.
• The option holder has the flexibility to exercise the
option whenever it is beneficial.
• Commonly used in U.S. markets for various financial
instruments, including stocks and stock indices.
Example:
1.Suppose you hold an American call option with a strike
price of $50 on Stock XYZ. If the stock price rises
significantly before the expiration date, you have the
flexibility to exercise the option and capture the profit.
 Strike Price and Option
Premium 34
• Strike Price:
• The price at which the option holder can sell the
underlying asset. The strike price is set when the
option contract is created and does not change

• Option Premium:
• The price paid by the buyer (holder) to the seller
(writer) of an option for the right, but not the
obligation, to buy or sell an underlying asset at a
specified strike price before or at the expiration
date
 Option Premium 35
• Determinants of Option Premium:
• Intrinsic Value: The difference between
the current market price of the underlying
asset and the option's strike price.
• Time Value: The value associated with the
time remaining until the option's expiration.
• Volatility: The degree of price fluctuation
of the underlying asset.
• Interest Rates: The prevailing risk-free
interest rates.
 Components of Option
Premium: 36
• Intrinsic Value: Reflects the actual value of the option if it were
exercised immediately.
• For call options, intrinsic value is
• max⁡(0,Underlying Price−Strike Price)
max(0,Underlying Price−Strike Price), and
• For put options , intrinsic value is
• max ⁡(0,Strike Price−Underlying Price)
max(0,Strike Price−Underlying Price).
• Time Value: Represents the value attributed to the time
remaining until expiration. It tends to decrease as the expiration
date approaches.
• Total Premium: The sum of intrinsic value and time value.
 Option Premium 37
• Let's say you purchase a call option on Stock
XYZ with a strike price of $50. The current
market price of XYZ is $55. The option premium
for this call option might be composed of both
intrinsic value and time value. If the intrinsic
value is $5 (the difference between the current
market price and the strike price) and the time
value is $2,
• Total Premium = Intrinsic Value + Time Value
Intrinsic Value (Call)=Current Stock Price−Strike P
rice
 Time Value in Option
Premium 38

• Time value in OP means that the portion

of option premium other than intrinsic
value is attributed to the time remaining
until the option's expiration.
• Time value decreases as the option
approaches its expiration date.
• Options with longer time to expiration
generally have higher time values.
• It represents the market's expectation of
future price movements.
Call Option
In the Money, At the
Money and Out of the 39
Money
 Example of ITM, ATM and
OTM in Call Option 40
• Suppose Stock ABC is currently trading at
$60.

• A call option with a strike price of $55 is in

the money.
• A call option with a strike price of $60 is at
the money.
• A call option with a strike price of $65 is
out of the money.
Put Options
In the Money, At the Money and Out
of the Money 41
Example of ITM, ATM and OTM
in Put Option 42

• Suppose Stock ABC is currently trading at

$60.

• A call option with a strike price of $65 is in

the money.
• A call option with a strike price of $60 is at
the money.
• A call option with a strike price of $55 is
out of the money.
 Option Price Determination 43

• Option pricing involves complex

mathematical models, and the most
well-known model is the Black-
Scholes-Merton (BSM) model.
Option Pricing with
Black-Scholes-Merton (BSM) 44
model.
 Example of Call Option
Pricing 45
• Let's consider an example where:
• Current stock price (S0​) = $100, Strike price (X) = $95
• Time to expiration (T) = 6 months
• Risk-free interest rate (r) = 0.05 (5%), Volatility (σ) =
0.2(20%)

• C =S0​⋅N(d1​)−X⋅e−rT⋅N(d2​)
• Calculate d1​and d2​:
d1=ln⁡(100/95)+(0.05+(0.2^2/2))⋅0.50.2⋅√0.5
• d1​=0.2⋅0.5​ln(100/95)+(0.05+(0.2^2/2))⋅√0.5​
• d2=d1−0.2⋅0.5d2​=d1​−0.2⋅√0.5​
 Solution Conti…………… 46
• The stock price 6 months from the expiration of
an option is $42, the exercise price of the option
is $40, the risk-free interest rate is 10% per
annum, and the volatility The Black–Scholes–
Merton Model 315 is 20% per annum. Calculate
the price of call option
 Swap 47

A swap is an agreement to exchange

cash flows at specified future times
according to certain specified rules
(traded on OTC)
• Notional Principal
• Counterparties: companies and swap
dealers (market makers)
 Example of Swap 48

• Company A has a floating-rate loan with

an interest rate linked to LIBOR, while
Company B has a fixed-rate loan. Both
companies decide to enter into an interest
rate swap to manage their interest rate
exposures. Company A wants to convert
its floating-rate payments to fixed-rate,
while Company B wants to convert its
fixed-rate payments to floating-rate.
 Types of Swaps 49
• Interest Rate Swaps (IRS):
• Definition: Interest rate swaps involve
the exchange of fixed-rate and floating-
rate interest payments between two
parties.
• Purpose: Companies may use interest
rate swaps to manage their exposure to
interest rate fluctuations. For example, a
company with a variable-rate loan might
want to convert it to a fixed-rate loan.
 Types of Swaps 50

• Currency Swaps:
• Definition: In a currency swap, two parties
exchange cash flows denominated in
different currencies over a specified period.
• Purpose: Currency swaps are used to
hedge against exchange rate risk or to
obtain a lower cost of borrowing in a
different currency.
 Types of Swaps 51

• Commodity Swaps:
• Definition: Commodity swaps involve the
exchange of cash flows based on the price
movements of commodities such as oil,
natural gas, or agricultural products.
• Purpose: Companies in the commodities
business use commodity swaps to
manage price risk. For instance, an oil
producer might enter into a commodity
swap to lock in a fixed price for its oil.
 Types of Swaps 52

• Equity Swaps:
• Definition: Equity swaps involve the
exchange of cash flows based on the
returns of an equity index or
individual stocks.
• Purpose: Investors might use equity
swaps to gain exposure to a particular
equity market without directly owning
the underlying securities.
 Types of Swaps 53

• Credit Default Swaps (CDS):

• Definition: Credit default swaps are a
form of insurance against the default of
a borrower. In a CDS, one party pays a
premium in exchange for protection
against a credit event.
• Purpose: CDS are often used to hedge
against credit risk or to speculate on the
creditworthiness of a particular entity.
 Types of Swaps 54

• Credit Default Swaps (CDS):

• Definition: Credit default swaps are a
form of insurance against the default of
a borrower. In a CDS, one party pays a
premium in exchange for protection
against a credit event.
• Purpose: CDS are often used to hedge
against credit risk or to speculate on the
creditworthiness of a particular entity.
 55
• Company A has a floating-rate loan with an interest
rate linked to LIBOR, while Company B has a fixed-
rate loan. Both companies decide to enter into an
interest rate swap to manage their interest rate
exposures. Company A wants to convert its floating-
rate payments to fixed-rate, while Company B wants
to convert its fixed-rate payments to floating-rate.
• Notional principal: $10 million
• Floating rate (Company A): LIBOR + 1%
• Fixed rate (Company B): 4.5%
• Swap duration: 2 years
• Payments: Semi-annual
 Solution of example 56
• Calculate the Net Cash Flow:
• For each payment period, calculate the net cash flow by
taking the difference between the fixed and floating rate
payments.
• Net Cash Flow=Fixed Rate Payment−Floating Rate Payment
• The fixed rate payment for each period is Fixed Rate ×
Notional Principal / 2
The floating rate payment is
(LIBOR+Spread)×Notional Principa/2
In this example, let's assume LIBOR is 3%.
• Net Cash Flow=(4.5%×10,000,000)/2−(3%
+1%)×10,000,000/2)
• Net Cash Flow=$225,000−$200,000=$25,000
 Continnue… 57
• Calculate the Present Value of Cash Flows:
• For each net cash flow, calculate the present
value using the appropriate discount factor. The
discount factor is determined by the time to the
payment and the applicable interest rate.
• Let's assume the discount factor is calculated
using the following formula:
• Discount Factor=1/(1+Swap Rate/
2)^Period Number
• If the swap rate is 4%, then the discount factors
for each period would be calculated accordingly.
 Continue 58
1.Sum the Present Values:
2.Sum the present values of the net cash
flows to find the total present value.
3.Settlement:
4.At the end of each period, settle the
net cash flow. If it is positive, Company
A pays Company B; if negative,
Company B pays Company A.