Futures and Forward:
Basics


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

Payoff
Market Mechanics
What drives the gains from trade?
Reading: Ch. 2

What is a Derivative?
Definition: A derivative is a financial instrument (contracts) whose value is based on the value of other underlying assets
Type of
Contract

Underlying
Assets

Forward/
Future

Investment
Asset

Options

Commodity

Swap

•
•
•
•

Stock Price
Interest Rate
Exchange Rate
…..

•
•
•
•

Energy: gas, Oil
Corn
Weather derivatives
….

Road Map
Payoff
Type of
Contract

Underlying
Assets

Forward
/ Future

Investment
Asset

Options

Commodity

Strategy

Swap

Pricing
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Plans for Forwards/Futures


Basics






Hedging Strategies (Ch.3)





Payoff and mechanics of Forward and Futures (Ch.2)
What drives the gains from trade?
Presentation 1: OTC vs. Centralized market
How to hedge properly as a firm/trader?
Presentation 2 : the use of derivatives

Pricing



Interest rates basics (Ch. 4)
Arbitrage pricing (Ch. 5)

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How Big Is the Derivative Market?

Source: Bank of International Settlements (www.bis.org)
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Forward Contracts


Definition: a binding agreement (obligation) to buy/sell an underlying asset at a predetermined date in the future, at a price set today



A forward contract specifies




The features and quantity of the asset to be delivered
The “expiration date”
The price the buyer will pay at the time of delivery: “the forward price”
Agreement
0

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Settlement/Delivery
T

time
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Features of Forward Contracts


Features of Forward Contracts








Customized
Non-standard and traded over the counter (not on exchanges) No money changes hands until maturity
Non-trivial counterparty risk

Futures contracts are the same as forwards in principle except for some institutional and pricing differences.

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Notation





S0: Spot price at time 0
ST: Spot price at time T
F0: Forward/Futures price at time 0
T: Time until delivery date (in years)

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Payoff on Forward Contracts


The payoff on a forward contract is its value at expiration. 

Payoff on a long position
= Spot price at expiration – Forward price
= ST – F0



Payoff on a short position
= Forward price – Spot price at expiration
= F 0– S T

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Payoff on Forward Contracts


The payoff on a forward contract is its value at expiration. 



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Agrees to buy the asset at time T

Payoff on a long position
= Spot price at expiration – Forward price
= ST – F0
(Pay F0 and get something worth ST)
Agrees to sell the asset at time T

Payoff on a short position
= Forward price – Spot price at expiration
= F 0 – ST
(Get F0 for something worth ST)

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At expiration

Payoff Diagrams
Long Position: Payoff
= Spot – Original Futures Price
= ST – F0 (at expiration)

ST

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Short Position: Payoff
= Original Futures Price - Spot
= F0 – ST (at expiration)

ST

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Cash Settlement



An alternative settlement procedure
Instead of requiring delivery of the asset, two parties make a net cash payment, which yields the same cash flow as if delivery had occurred


Why?




A physical transaction likely have transaction costs

Example: The stock index ST=$1040 ; F0 =$1020


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Net payment $20 from the short position to the long
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Example: Gold-diggers
A gold-mining firm enters a short forward contract, agreeing to sell gold at a price of $850/oz. in 1 year
 What is the payoff on this short forward position?


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ST

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Questions


Why entering this contract?



Who might want to take the long position of this contract?

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Why entering this contract?