Forward, Futures, and Swaps: Forward, Futures, and Swaps The first section of the course will cover forward, futures and swaps. Relevant Chapters in Textbook (4th edition) Mechanics of Futures and Forward Markets (Ch. 2) The Determination of Forward and Futures Prices (Ch. 3) Hedging Strategies using Futures (Ch. 4) Interest-Rate Futures (Parts of Ch. 5) Swaps (Ch. 6)


Mechanics of Futures and Forward Markets: Mechanics of Futures and Forward Markets Chapter 2


Futures Contracts: Futures Contracts Available on a wide range of underlyings Exchange traded Specifications need to be defined: What can be delivered, Where it can be delivered, & When it can be delivered Settled daily


The Elements of Standardization of Futures Contracts: The Elements of Standardization of Futures Contracts The Asset The Contract Size Delivery Arrangement Price Trading hours


IMM 3-Month Eurodollar Futures ContractExample of Futures Contract Standardized Terms: IMM 3-Month Eurodollar Futures Contract Example of Futures Contract Standardized Terms


Henry Hub Nature Gas Futures Example of Futures Contract Standardized Terms: Henry Hub Nature Gas Futures Example of Futures Contract Standardized Terms


Roles of the Clearinghouse: Roles of the Clearinghouse Interjects itself as the counterparty to all transactions Every exchange-traded derivative contract has the same default and settlement risk equal to the risk of the clearinghouse defaulting Oversees Margins Initial, Maintenance Daily Marking-to-Market


Margins: Margins A margin is cash or marketable securities deposited by an investor with his or her broker The balance in the margin account is adjusted to reflect daily settlement Margins minimize the possibility of a loss through a default on a contract


Example of a Futures Trade: Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 contract size is 100 oz. futures price is US$400 margin requirement is US$2,000/contract (US$4,000 in total) maintenance margin is US$1,500/contract (US$3,000 in total)


Daily Mark-to-Market Example: Daily Mark-to-Market Example Initial Margin=$1,875. Maintenance Margin = $1,500.


Other Key Points About Futures: Other Key Points About Futures They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity


Delivery: Delivery If a contract is not closed out before maturity, it usually is settled by delivering the assets underlying the contract. When there are alternatives about what is delivered, where it is delivered, and when it is delivered, the party with the short position chooses. A few contracts (for example, those on stock indices and Eurodollars) are settled in cash


Some Terminology for Futures: Newspaper Quotes: Some Terminology for Futures: Newspaper Quotes Open interest: the total number of contracts outstanding equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day used for the marking-to-market process Volume of trading: the number of trades in one day


Convergence of Futures to Spot (Figure 2.1, page 20): Convergence of Futures to Spot (Figure 2.1, page 20) Time Time (a) (b) Futures Price Futures Price Spot Price Spot Price


Regulation of Futures: Regulation of Futures Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups


Forward Contracts: Forward Contracts A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price There is no daily settlement. At the end of the life of the contract one party buys the asset for the agreed price from the other party


How a Forward Contract Works: How a Forward Contract Works The contract is an over-the-counter (OTC) agreement between 2 companies No money changes hands when first negotiated & the contract is settled at maturity The initial value of the contract is zero


Example Table 2.5, Page 36: Example Table 2.5, Page 36 Investor A enters into a long forward contract to buy £1,000,000 @ 1.8381 US$/£ in 90 days Investor B enters into a long futures contract to buy £1,000,000 @ 1.8381 US$/£ in 90 days The exchange rate is 1.8600 US$/£ in 90 days Investor A makes a profit of $21,900 on day 90 Investor B makes a profit of $21,900 over the 90 day period


Long Forward Contract: Long Forward Contract Contract Price


Short Forward Contract: Short Forward Contract Contract Price


Forward Contracts vs Futures Contracts: Forward Contracts vs Futures Contracts Private contract between 2 parties Exchange traded Non-standard contract Standard contract Usually 1 specified delivery date Range of delivery dates Settled at maturity Settled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDS FUTURES TABLE 2.4 (p. 34)


Foreign Exchange Quotes: Foreign Exchange Quotes Futures exchange rates are quoted as the number of USD per unit of the foreign currency Forward exchange rates are quoted in the same way as spot exchange rates. This means that GBP, EUR, AUD, and NZD are USD per unit of foreign currency. Other currencies (e.g., CAD and JPY) are quoted as units of the foreign currency per USD.