Topic 4 Introduction to forwards and futures
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1 Topic 4 Introduction to forwards and futures 1. Forward contracts & uses 2. Futures contracts, markets & uses 11/11/2013 Pr. Didier Folus 1
2 1. Forward contracts and uses 1.1. Definition & example Agreement to buy or sell an underlying asset at a fixed price F t and on a fixed date T in the future, for defined grade, quantity & place of delivery. Example of a forward contract on t = March 1, 2013 : Asset Nominal amount 1 Yellow grain field corn 50,000 bushels (bu) Negotiated price between 2 counterparts Forward price F t 4.00 USD/bu Buyer United Grain Brokers Corp. Seller Corn Grower ltd. Maturity date May 31, 2013 Place of delivery Saint-Louis City, MO Commitment to pay USD Commitment to deliver bu 11/11/2013 Pr. Didier Folus 2
3 Example of cash bids : S t price F t price 11/11/2013 Pr. Didier Folus 3
4 1.2. Basis evolution Basis on t = F t S t Considering maturity T = Jan 31, 2013 : Forward price Spot price prime contango Nov. 7 : basis t=0 = = USD Nov. 8 : basis t=1 = = USD Nov. 9 : basis t=2 = = 0.03 USD Jan. 31 : basis t=86 = 0.00 USD discount backwardation 11/11/2013 Pr. Didier Folus 4
5 1.3. Using forwards for hedging Commodity consumer case On t, the Kellog s Co. needs 50,000 bushels of corn, deliverable on T = t + 3 months : spot price S t = 3.60 USD/bu 3 month-forward price... F t = 4.00 USD/bu Solution 1 : buying spot on t storage Solution 2 : buying spot on T Not risky / carrying cost Not costly / risky 11/11/2013 Pr. Didier Folus 5
6 «loss» «profit» Solution 3 : buying forward on t for delivery on T : deposit 3 % on t. USD settling on T USD deposit receiving on T 50,000 bu of corn Forward long position at maturity : F t = 4.00 USD/bu Effective hedging price decrease price increase S T Cost of hedging 11/11/2013 Pr. Didier Folus 6
7 Commodity producer case On t, a farmer expects a 50,000 bushels corn-crop, deliverable on T = t + 3 months : spot price S t = 3.60 USD/bu 3 month-forward price F t = 4.00 USD/bu Solution 1 : selling spot on T Solution 2 : selling forward on t for delivery on T deposit 5 % on t. USD delivering on T.. 50,000 bu of corn receiving on T USD deposit 11/11/2013 Pr. Didier Folus 7
8 1.4. Using forwards for speculation Speculator, owning USD , expecting a future corn price increase Decision on t : buying forward 50,000 bu of corn at a price of F t = 4.00 USD/bu, settling on T : deposit on t... USD settling on T. USD deposit receiving + selling corn on T.. USD S T 50,000 result on T (in USD) USD (S T F t ) 50,000 return on T (in %)... (S T F t ) 50,000 /deposit gearing 11/11/2013 Pr. Didier Folus 8
9 1.5. Using forwards for arbitrage On t, an arbitrageur, having a limit of USD : borrows cash USD at 5⅓ % for 90 days buys corn spot. 75,000 bu of corn, paying USD stores corn... 75,000 bu of corn, paying USD sells corn forward 75,000 bu of corn On T, the arbitrageur : delivers corn 75,000 bu receives cash USD reimburses USD USD interests «Riskfree» profit on T (locked on t) : USD Numerous arbitrageurs make disappear the profit quickly 11/11/2013 Pr. Didier Folus 9
10 1.6. Forwards features About forward contracts : high nominal effective delivery non-tradable on a secundary market counterparty risk customized instruments About forward markets : major underlying assets : currencies, interest rates, commodities... participants : corporations & banks trading the physical asset brokers quotes & market reports 11/11/2013 Pr. Didier Folus 10
11 Market quotes : USD in London Source : Financial Times, March, Bid, offer, mid spot rates & forward rates are derivate from Reuters S t F t,1 month F t,3 months F t,1 year 11/11/2013 Pr. Didier Folus 11
12 2. Futures contracts and markets 2.1. Definition and example Futures contract : exchange traded commitment to pay/deliver an asset for a specific time, place, grade and quantity. Futures price appears through trades, for each maturity. Each buyer/seller faces a margin 11/11/2013 Pr. Didier Folus 12
13 USD Corn futures quotes USD /11/2013 Pr. Didier Folus USD
14 Dec 2012 corn futures chart Futures use forwards 11/11/2013 Pr. Didier Folus 14
15 2.3. The operation of margins CME corn futures (up to Sep 2013) : initial margin = USD 2,700 per contract maintenance margin = USD 2,000 per contract Margin is a SPAN parameter Standard Portfolio Analysis of Risk performance On t = Nov 7, 2012, an operator buys 10 CME SEP13-corn futures contracts, at USD 6.60 : commitment to pay = USD 330,000 maturity. # 11 months deposit 2, = USD 27,000 The broker/bank opens a margin account The CME Clearing operates margins 11/11/2013 Pr. Didier Folus 15
16 Margin account running : Date Settle Quote cents/bu Daily result USD Margin account balance USD Margin call USD Cumulative result USD Nov Nov Nov Nov Nov Maintenance margin : USD 2,000 per contract Futures contracts are daily marked to market 11/11/2013 Pr. Didier Folus 16
17 2.4. The clearing house Functions of the clearing house Authorizing members Being the counterpart of each transaction (registration) Guaranteeing full termination of operations Fixing the deposit Calculating and calling margins, every day Organizing delivery and settlement 11/11/2013 Pr. Didier Folus 17
18 Rising demand for OTC clearing Increasing demand for clearing operations outside the Exchange traded universe : forwards, IRS, CDS Ex. : freight derivatives strong increase in the business of shipping goods to China shipping rate volatility : hurricanes, oil prices freight forwards : OTC traded, cash-settled OTC clearing facilities : clearing houses exchanges banks Baltic Dry Index Source : Bloomberg, March 3, /11/2013 Pr. Didier Folus 18
19 2.5. Market data from Futures Industry Assoc. 11/11/2013 Pr. Didier Folus 19
20 Source : FIA Mag, March /11/2013 Pr. Didier Folus 20
21 Source : FIA Mag, March /11/2013 Pr. Didier Folus 21
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Topic 4 Forwards and futures 1. Forward contracts & uses 2. Futures contracts, markets & uses 3. Comparing futures hedge vs forwards hedge 09/11/2010 Pr. Didier Folus 1 1. Forward contracts and uses 1.1.
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