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Mechanics of Futures and Forward Markets Chapter 2

Mechanics of Futures and Forward Markets Chapter 2. Forward Contracts. A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price At the end of the life of the contract one party buys the asset for the agreed price from the other party.

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Mechanics of Futures and Forward Markets Chapter 2

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  1. Mechanics of Futures and Forward Markets Chapter 2

  2. Forward Contracts • A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price • At the end of the life of the contract one party buys the asset for the agreed price from the other party

  3. How a Forward Contract Works • The contract is an over-the-counter (OTC) agreement between 2 companies • No money changes hands when first negotiated & the contract is settled at maturity

  4. The Forward Price • The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract value or worth exactly zero) • The forward price may be different for contracts of different maturities

  5. ExampleTable 2.7, Page 42 • May 8: a company enters into a LONG forward contract to BUY £1,000,000 @ 1.8381 US$/£ in 90 days • August 6: the exchange rate is 1.8600 US$/£ • In accordance with the contract terms , the company pays US$1,838,100 & receives £1,000,000; • The company’s profit is US$21,900 since the sterling can be immediately sold for US$1,860,000

  6. Forward Exchange QuotesSterling-US$ Exchange Rate • Spot 1.8470 US$/£ • 30-day forward 1.8442 US$/£ • 90-day forward 1.8381 US$/£ • 180-day forward 1.8291 US$/£ • What should we expect to happen to the £ in the next 6 months? • Other currencies are quoted as units of foreign currency per US$

  7. Profit Price of Underlying at Maturity Profit from aLONG Forward Position

  8. Profit Price of Underlying at Maturity Profit from a SHORT Forward Position

  9. Futures Contracts • Available on a wide range of underlyings • Exchange traded • Specifications need to be defined by the Board of the exchange: • What can be delivered, • Where it can be delivered, & • When it can be delivered • Amount of asset to be delivered per contract

  10. Futures and Spot Prices at Settlement • What would you do if the instant before settlement of a futures contract you noticed the futures price was greater than the spot price of gold? • What would you do if the instant before settlement of a futures contract you noticed the futures price was less than the spot price of gold?

  11. 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$400 • margin requirement is US$2,000/contract (US$4,000 in total) • maintenance margin is US$1,500/contract (US$3,000 in total) • Note margin is not a function of either the spot or futures price

  12. Marking to Market • Marking to market means that futures contracts are settled at the close of each trading day • Marking to market results in the value of the futures contract being reset to zero at the close of each day unlike forward contracts

  13. A Possible OutcomeTable 2.2, Page 24See MtoM&M.xls Daily Cumulative Margin Futures Gain Gain Account Margin Price (Loss) (Loss) Balance Call Day (US$) (US$) (US$) (US$) (US$) 400.00 4,000 5-Jun 397.00 (600) (600) 3,400 0 . . . . . . . . . . . . . . . . . . 13-Jun 393.30 (420) (1,340) 2,660 1,340 4,000 + = . . . . . . . . . . . . . . . . . 3,000 < 19-Jun 387.00 (1,140) (2,600) 2,740 1,260 4,000 + = . . . . . . . . . . . . . . . . . . 26-Jun 392.30 260 (1,540) 5,060 0

  14. Other Key Points About Futures • Closing out a futures position involves entering into an offsetting trade • Most contracts are closed out before maturity

  15. 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 marking to market process • Volume of trading: the number of trades in 1 day

  16. Questions • When a new trade is completed what are the possible effects on the open interest? • Can the volume of trading in a day be greater than the open interest?

  17. Regulation of Futures • Regulation is designed to protect the public interest • Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

  18. Accounting & Tax • If a contract is used for • Hedging: it is logical to recognize profits (losses) at the same time as on the item being hedged • Speculation: it is logical to recognize profits (losses) on a mark to market basis • Roughly speaking, this is what the treatment of futures in the US & many other countries attempts to achieve

  19. Forward Contracts vs Futures Contracts • TABLE 2.6 (p. 39) FORWARDS FUTURES Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at maturity Settled daily Delivery or final cash Contract usually closed out settlement usually occurs prior to maturity

  20. Forward Price vs Futures Price • In theory, the futures price for a contract should be almost the same as the forward price for a contract with the same maturity on the same asset.

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