Lecture 17 Flashcards
Forward =
Deferred-delivery sale of asset with the sales price agreed now
Futures =
Similar to forward but the feature is formalised and standardised by contracts
Key differences between forward and future (3)
- Standardised contracts create liquidity
- Marked to market
- Exchange mitigates credit risk
Futures contract =
Obligation to make/ take delivery of an underlying asset at a predetermined price
Futures price =
Price for underlying asset is determined today, but settlement is at a future date
Futures contract specifies
Quantity and quality of underlying asset and how it is delivered
Long =
Commitment to purchase commodity on a delivery date
Short =
Commitment to sell commodity on delivery date
Futures are traded
On a margin
At the time the contract is entered into
No money changes hands
Profit to long =
Spot price at maturity - original futures price
Profit to short =
Original futures price - sport price at maturity
Futures contract = zero sum game
Gains and losses net out to zero
Unlike call option, payoff to long position can be negative because
Futures trader cannot walk away from the contract if it is not profitable
Exchange acts as
Clearing house and counter-party to both sides of the trade
Net position of a trading house =
0
Open interest =
Number of outstanding contracts
If currently in a long position, will instruct trader to
Enter short side of contract to close out position
Most futures contracts are closed out by
Reversing trades
Marking to market =
Profits/ losses from the new futures price are paid over or subtracted from the account
Convergence of price =
Movement of the price of a futures contract towards the spot price of the underlying cash commodity as the delivery date approaches. The two prices must converge, or else traders would exploit any price difference to make a risk-free profit
Initial margin =
Funds/ interest earning securities deposited to provide capital to absorb losses
Maintenance margin =
Established value below which trader’s margin may not fall
Margin call =
When the maintenance margin is reached, the broker will ask for additional margin funds
Speculators
Seek profit from price movements
Short
Believe the price will fall
Long
Believe the price will rise
Hedgers
Seek protection from price movements
Long hedge
Protecting against a rise in the purchase price
Short hedge
Protecting against a fall in the selling price
Why buy futures contract instead of just underlying asset? (2)
- Lower transaction costs
- Provides leverage
Basis =
Difference between the futures price and the spot price Ft- Pt
Convergence property states that at maturity
Ft - Pt = 0
Basis risk =
Variability in basis means that gains and losses on contract and asset may not perfectly offset if they are liquidated before maturity
Spot-Futures parity theorum states there are two ways to acquire asset for a date in the future
- Purchase now and store it
- Take long position in futures
With a perfect hedge
Futures pay-off = certain therefore no risk, therefore should earn riskless rates of return
