CHAPTER 7

FORWARD AND FUTURE CONTRACTS

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7.1 Forward Contracts:
A forward contract is a particularly simple derivative. It is an
agreement to buy or sell an asset at a certain future time for a certain price. A
forward contract is traded in the over the counter market, usually between two
financial institutions or a between a financial institution and one of its clients.

Definition 7.1.1: (Forward contract)

A forward is an obligation to buy (or sell) an asset at the specified forward or
delivery price, , at a known time, . A forward is an agreement and does not
involve any payments when it is entered into at time t.

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Spot and forward quotes for the exchange rate, August 16, 2001(GBP= British
pound, USD= U.S. Dollar)

Bid ( Buy)
Spot 1.4452
1 -month Forward 1.4435
3 - month Forward 1.4402
6 - month Forward 1.4353
1 - year Forward 1.4362

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Contact singed (t = 0) t = T (future)

Profit Loss
Buyer >K <K
Seller <K >K

Payoff from forward contracts

(a) Pay off long position on forward contract on one unit of an asset is .
(b) Pay off short position on forward contract on one unit of an asset is .

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Example 7.1.1:
On January 20,2010, a refiner enters into an agreement with a crude oil supplier to
buy one million barrels in three months time at a rate of USD 50/ barrel. What are
the cash flow consequences on the delivery date for the refiner and the supplier if
the spot rate of crude oil is (a) USD 55 and (b) USD45 a barrel?

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7.1.2 Forwards vs. Options
Consider a farmer who at time can enter into a forward contract to sell an asset for in at
time or buy a European put option, with strike that matures at time T
• The farmer is concerned that the price of his produce will fall. If at time T, (i.e. the
produce price is high)
• If a farmer enters into a forward contract, the price they receive at delivery is fixed; the
farmer does not gain the upside
• If the farmer buys a put, the farmer can sell their produce in the market, rather than to the
holder of the forward, benefiting from the upside.
- But they would have had to pay the premium,

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7.1.3 Mechanics of Forwards
• At some time t one party agrees to sell another party an asset for a specified
price at a definite time T > t.
- The party selling the asset is described as being short on the forward
contract.
- The party buying the asset is described as being long on the forward
contract.

• The price agreed, is known as the forward or delivery price.

At time t < T no money changes hands,
At time passes from the long to the short party.
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• If, at time , a person goes long a forward for delivery at and at goes short on a

similar forward for delivery at .

- The person starts with no asset, and spends no money
- At person essentially ends up with no asset but money does change
hands
* They receive the asset and immediately give it to someone
else
* They pay and get
* This strategy makes money if .

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 7.1.4 Long or Short
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• Being “short" does not mean you do not have something,
- being “short" means that you do not have something now that you must
have in the future
- traditionally, you are short if you have borrowed an asset from its owner
and so need to return it to its owner
• Consider the two parties in a forward contract, the seller and the buyer of the
underlying asset in the future
- The seller holds the underlying asset
* So they are long the asset, implying they will be short the forward
* They will sell the asset in the future, which means they are short the
forward
* Historically, the seller of the asset is hedging 02/15/2025
 - The party who agrees to buy the underlying in the future
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* They are short the asset
* They will buy the asset in the future, which means they are long
the forward
* Historically, the buyer of the asset is speculating
· They are taking on the price risk
• If you are both “long" and “short"
- If you are long, you hold the asset
- If you are short, you have borrowed an asset that needs returning to its
owner
- If you use the asset you are long to return to the owner, you cancel your
short position and lose your long position
you do not have a position. 02/15/2025
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Example 7.1.2:
Thales is often referred to as the “father of western science" because around 700
BCE he investigated the nature of energy and matter, which was eventually
resolved by Einstein with . The Greek philosopher, about 300 BCE reported that
Thales was also the first person to make Derivative Markets and money by using
his scientific knowledge, specifically he believed there would be a bumper crop of
olives and so bought up all the olive presses.
Say, in June, you believe there is going to be a bumper olive crop, which is
harvested in September. Would you

• Go long on olive forwards

• Go short on olive forwards
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 If you expect olive prices to fall, you want to go short on the forward, since the payoff of
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being short is decreasing, the lower the price the more you will make. You would make the
money by buying the cheap olives in the market and selling them to the counter party on the
forward at the higher forward price.
The forward price in June is
Unfortunately, in August there is a freak frost that destroys much of the olive crop. Is this
good or bad news?
It is bad news, there are not going to be cheap olives in the market in September and you
decide to cut your losses by cancelling the short forward you hold by entering into a long
forward. But other speculators in the market are doing the same thing, creating more demand
for long forward contracts, which in turn pushes the delivery price up, so the forward price
up to
In September you have to buy olives for $15 and sell them for $10 and you make a loss of
$5, maybe without ever seeing an olive.
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13 7.1.5: Specification of a Forward Contract
• The contract multiple. This is usually given as a price per point. For example
- the FTSE index may be sold at “$100 per point"
- this means that if the FTSE moves from 5100 to 5110, the value of one
forward contract will change by
• The exact details of the asset
Complex for commodities
• Contract size (how much of the asset will be delivered)

• Where and when delivery will be made

- If alternatives are allowed it is usual for the short party (the party making
the delivery) to select the alternative.
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• How prices are quoted

• Tick size and limits on daily price movements
- if the FTSE index has a contract multiple of “$100 per point"
- the minimum tick move could be set at $1, or 1=100th of a FTSE point
• Position limits
- Speculators are often restricted in the number of contracts they can take out
- Ensures that they do not adversely affect the real economy
• How the price paid will be determined
- Important in some price-discovery markets

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15 7.2 Futures
7.2.1 Introduction
• A forward contract does not involve payment until maturity
• Futures trading requires the maintenance of a margin account
- The initial margin is a sum of money per contract which must be paid to the
exchange on taking out the contract
- The maintenance margin is a limit such that if the margin account drops
below that level, the margin must be topped up to the initial margin level.
- The margin account is maintained by topping it up to cover losses on the
futures price
- * If gains are made, cash can be withdrawn from the margin account
- Margin accounts usually pay interest (related to LIBOR)
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 • All exchange traded forward contracts require a margin
16
- All exchange traded forward contracts are futures contracts
- Today, many OTC contracts require margins as well

Definition 7.2.1: (Futures contract)

A future is a forward contract that requires a margin account.

Example 7.3.1: (Margins)

A trader contacts a broker on the NY Commodity Exchange (COMEX) about gold

futures. The current futures (delivery) price of the contract is $600/ounce and each
contract is for 100 ounces. The trader, expecting a price rise, decides to long futures
contracts for 200 ounces, which will be two contracts and cost .
The initial margin is $2,000 per contract, and this must be deposited in a margin
account at the exchange. The maintenance margin is $1, 500. The trader enters into
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the futures and deposits the margin of .

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18 7.2.2 Margin accounts
• An initial margin (per contract) must be deposited on entering into a futures contract
• For everyone long a futures contract, there is someone short { if the margin account of the
long party is increasing, the margin account of the short party decreases
- If the futures price moves
* in a positive way, the margin account gets bigger
* in a negative way, the margin account gets smaller
• If the value of the margin account hits the maintenance margin (below the initial
margin)
- a margin call is made
- the variation margin resets the margin account to the initial margin
• If a person is long and short a future, the value of this portfolio is zero, whatever the state of
the market.
- gains /losses of being long are matched precisely by losses/gains of being short 02/15/2025
 Difference between Forwards and Futures:
19 Features Forwards Futures
Deal are done on Over the counter market Organized Exchanges
Price Risk Eliminated Eliminated
Performance/Credit Present Eliminated
Risk
Liquidity low Generally high
Terms and Conditions, Customized Standardized
contract size
delivery date Usually one specified Range of delivery dates
delivery date
Settle Settled at end of contract Settled daily
Delivery or final cash Contract is usually closed
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settlement usually takes out prior to maturity.
 7.3 Convergence of Futures price to the Spot Price
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As the delivery month of a futures contract is approached the futures
price convergence to the spot price of the under lying asset. When the delivery
period is reached, the future price equals or is very close to the spot price.

7.4 Determination of forward and future Prices:

Assumptions:
a. There are no transaction cost
b. All trading profits (net of trading losses) are subject to the same tax rate.
c. The market participations can borrow money at the same risk-free rate of
interest as they can lend money.
d. The market participants take advantage of arbitrage opportunities as they
occur. 02/15/2025
21 Notations:
T - Time until delivery date in forward contact (in years)
- Price of asset under lying forward contact today
K - Delivery price in forward contact
f – Value of a long forward contact today
F - Forward price today
r – Risk free interest rate per annum, with continuously compounding for an
investment making of the delivery date

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Forward prices for a security that provide no income

Example 7.2:
Consider a four month forward contract to buy a zero- coupon bond that
will mature one year from today. The current price of the bond is $930. (This means
that the bond will have eight months to go when the forward contract matures) The
four – month risk free rate of interest (continuously compounded) is 6%pa.
Determine the forward price.

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Forward price for a security that provides known cash income:

I - Present value of known cash income

Example 7.3:
Consider a 10-month forward contract on a stock with a price
of $50. The risk free interest rate is 8%pa for all maturities. Assume that dividends of $0.75
per share are expected after three months, six months and nine months. Determine the value
of the forward contract.

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Forward prices for a security that provide a known dividend yield

Dividend yield is paid continuously at an annual rate q.

Example 7.4:
Consider a six month forward contract on an asset that is expected to
provide income equal to 2% of the asset price once during a six month period.
The risk free interest rate is 10%pa. The asset price is $25. Determine the
forward price of the asset

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 Valuing forward contacts
25
- Value of a long forward contract
– Delivery price in contract
The value of long forward contact

For value of a forward contact for a security that provides known cash
income:

Forward prices for a security that provide a known

dividend yield
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Example 7.5:
A long forward contract on a non-dividend – paying stock was entered
into some time ago. It currently has six months to maturity. The risk free rate of
interest is 10%pa. the stock price is $25 and the delivery price is $24. Find the
value of long forward contract.

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7.5 The relationship between forward prices and future prices (J. C. Cox, J.
E. Ingersoll and S. A. Ross)
- Interest rate (constant)

– Days
- Future price at the end of ith day ( )
- Risk free rate per today
1. Take long future position of at the end of day 0
2. Increase the long position to at the end of day 1
3. Increase the long position to at the end of day 2 and so on
The investment strategy to show that futures and forward prices are equal

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28 Day 0 1 2 n -1 n

Future
Price
Future 0
Position
Gain/ Loss 0

Compound 0
to day n

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For forward price at the end of day is by investing in a risk less bound and
takes a long forward position of forward contacts an amount is also
guaranteed at time T.
There are two investment strategies, one requiring an initial of , other requiring
an initial of both which yield of time T.
Therefore, absence of the arbitrage opportunities .

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 7.6.1 Basic Hedging with Forwards/Futures
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7.6.1.1 Long and Short Hedging
• Derivatives provide speculators with the opportunity to increase the gearing of
their investments.
• Derivatives enable hedgers to reduce the gearing of their investments.
-A company knows it will sell an asset at a particular time in the future
* Takes a short forward position - short hedge
- A company will buy an asset in the future
* Takes a long forward position
• Rule of thumb for hedgers
- If you are long the asset, to hedge, shorts the forward/future.
- If you are short the asset, long the forward/future.
- If you are long on the future, to hedge, short the asset. 02/15/2025

- If you are short on the future, buy the asset.

31 Hedging Strategies for Different Spot market Positions:

Currant Status Concerned about Hedge

Holding the asset Asset price may fall Short

About to buy the Asset price may rise Long

asset
Sold short the asset Asset price may rise Long

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 Example 7.6.1.1 (Long Hedge)

32 You run a holiday company in Scotland and in august you will require 20,000 metric tons of
kerosene (aviation fuel) and you are concerned the price of kerosene will rise. Nymex offers
a North West Europe kerosene contract which is priced at $1,163/ton. Since you want to buy
the kerosene you are short the asset and so go long the future. In August, kerosene has in fact
dropped to $1,053/ton, and the futures price has converged to the asset price. Can you beat
the hedge?
The value of the future has changed resulting in a profit of

You could buy your kerosene on the open market, at a cost of $1. 053/ton, so your overall
position is
Cost of buying the kerosene + profit on futures =

So the total cost is and you have locked in the price

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 Example 7.6.1.2 (Short Hedge) At you hold a share whose price is and is at a
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high. You don't want to sell the equity today but you wish to liquidate your assets in
three months time, and the forward price of this equity for delivery in three months
time is , can you lock in this price, of ?

You are long the asset - so go short the future, meaning you agree to sell the asset in
the future After three months, , the share price has fallen to $90, and as we are at
delivery in a cash-and-carry market, the futures price has converged to the
underlying asset's price.
The value of your portfolio is

a minus sign because you are short the future

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7,6.1.2 No futures contract to match your asset?
• What happens if a futures contract on the exact underlying is not available?
- A futures contract is very specific
-Forward markets are not so transparent as futures markets
• If you produce (or need) oil that does not match the future, what do you do?
• What about price discover markets where the product you hold is different from
the paper contract?
- Electricity, milk etc. cannot be stored
-What is meant by the 'spot' price
The difference between the spot price of the asset and the futures price is
known as the basis
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 7.6.1.3 Basis

35
• If the spot price increases faster than the forward price, then the basis strengthens
• If the basis gets smaller, it weakens.
• If the basis is negative
- Implies that the price of a commodity for future delivery is higher than the current price
of the commodity
- This situation is known as contango
- The `normal' state of most markets

• If the basis is positive

- The spot price is above the forward price
- Called backwardation
- The market is inverted
* Short term demand for the commodity is high 02/15/2025

* Short term supply is low

36 7.7 Minimum variance Hedge Ratio
The hedge ratio is the ratio of the size of the position taken in futures
contacts to size of the exposure.
If the objective of the hedger is to minimize risk setting the hedge ratio
equal to one is not necessarily optimal.
- Change in spot price , during a period of the time equal to the life of the
hedge.
- Change in the futures price , during a period of the time equal to the life
of the hedge.
- Standard deviation of .

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37
- Standard deviation of.
- Coefficient of correlation between and .
- Hedge ratio that minimize the variance of the hedger’s position.
Suppose we expect to sell units of an asset at time and choose hedge at time by
shorting futures contract on units of a similar asset.
The hedge ratio

Total profit or loss

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 Where and
38 To minimize (Loss or Profit) need to minimize . Since and are known
quantities.

Therefore

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39 In practice, the minimum variance hedge ratio is estimate as the slope coefficient
of the least squares regression between , That is hedge ratio is expected from the
regression equation:

Therefore, optimal number of contracts to be bought or sold in the

following way:

Where Number of units of spot asset to be hedge

minimum variance hedge ratio
Quantity of asset underlying a single futures contract
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 7.8 Options on Futures:
40
Options on futures also known as futures options, an exercise of the
option give the holder the right to buy or sell the asset at the agreed price at a
future date. An option on a future is the right but not obligation, to trade a futures
contact at a certain futures price by a certain time. The most futures options are
American. They are referred to by the month in which the underlying futures
contract matures. The maturity date of a futures option contract is usually on or a
few days before, the earliest delivery date of the underlying futures contract.
If a call futures option is exercised, the holder acquires a long position in
the underlying futures contract plus a cash amount equal to the most recent
settlement futures price minus the strike price. If a put futures option is exercised,
the holder acquires a short position in the underlying futures contract plus a cash
amount equal to the strike price minus the most recent settlement futures price. 02/15/2025
 Example 7.7:

41 An investor has one September futures call option contact on copper with
strike price of 70cents per pound on 15th August. One futures contract is on 25,000
pounds of copper. Suppose that the futures price of copper for delivery in
September is currently 81 cents, and at the close of trading on August 14 (the last
settlement) it was 80 cents. If the option exercises how much the investor received?

Put- call parity

Consider two portfolios:

Portfolio A: A European call futures option plus an amount of cash equal
to
Portfolio B: A European put option plus a long futures contact plus an amount
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of cash equal to
42 Example 7.8:
Suppose that the price of a European call option on silver futures for delivery
in six months is 56 cents per ounce when the exercise price is $ 8.50. Assume that
the silver futures price for delivery in six months is currently $8.00 and the risk-
free interest rate for an investment, which matures in six months, is 10% p.a.

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8.8 Valuation of Futures options using Binomial Model:

Risk natural probability

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8.9 Black’s Model for Valuing Futures Options

Where

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Example 7.9:
Consider a European put option on crude oil. The time to the option’s
maturity is 4 months, the current futures price is $20, the exercise price is $20,
the risk-free interest rate is 9% per annum, and the volatility of the futures price
is 25%per annum. Find the value of European put option.

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