4 Futures and Forwards Flashcards
Define forwards contract
A commitment to buy (sell) at a future date a given amount of a commodity or an asset at a price agreed on today.
Price and position in forward contracts
- Price fixed now for future exchange is the forward price
- Buyer obtains a “long position” in the asset/commodity, seller a “short position”
Features of forward contracts (3)
- Traded over the counter (not on exchanges)
- Custom tailored
- No money or goods change hands until maturity
Advantages and disadvantages of forward contracts
+ Flexibility in terms of contact
- Illiquidity
- Counterparty risk
Define futures contract
An exchange-traded, standardized, forward-like contract that is marked to the market daily
Features of futures contracts (5)
- Standardized
- Based on underlying commodity or asset
- Quantity
- Maturity
- Traded on exchanges that act as clearing house
- Gains/losses settled daily (marking to market, daily settlement)
- Margin account required as collateral to cover losses
- Little counterparty risk
Suppose: a tofu manufacturer needs 100,000 bushels of saybeans in 3 months. Spot (current) price is $12.50/bu but may increase. Manufacturer wants to make sure that 100,000 will be available.
Solution as a forwards contract.
3-month forward for 100,000 at $12.91/bu
Short side (farmer wanting to lock in a price, or speculator): short position of 100,000 at $12.91/bu in 3 months
Settlement occurs in 3 months when the manufacturer recieves the bushels and pays for them.
Suppose: a tofu manufacturer needs 100,000 bushels of saybeans in 3 months. Spot (current) price is $12.50/bu but may increase. Manufacturer wants to make sure that 100,000 will be available.
Solution as a futures contract
3-month futures for 100,000 at $12.91/bu
Long side (manufacterer) buys 100,000 from short side at $12.91/bu in 3 months.
Short side (farmer or speculator) has short position of 100,000 bushels at $12.91/bu in 3 months.
If the price of soybeans falls (rises), the buyer (seller) must make payments to reflect the shift.
Settlement in 3 months, buyer pays spot price for soybeans, but has benefitted (lost) from the fixed price of the future if the spot price is higher (lower).
Cashflow differences between forward and futures contracts
Payoff diagram for long and short positions
Two ways of buying an underlying asset for date-T delivery
- Buy a forward or futures contract with maturity date T
- Buy the underlying asset and store it until T
Valuation of forward contract vs outright asset purchase
Total cost at T of an outright asset purchase (equation)
How does the cost of a forward contract relate to outright asset purchases?
Commodity future: gold equation. Why?
Commodity future: oil equation. Why?
Commodity future: stock index future equation. Why?
