Forward - an agreement calling for a future delivery of an asset at an agreed-upon price
Futures - similar to forward but feature formalized and standardized characteristics
Key difference in futures
Secondary trading - liquidity
Marked to market
Standardized contract units
Clearinghouse warrants performance Futures and Forwards

Key Terms for Futures Contracts:

Futures price - agreed-upon price at maturity
Long position - agree to purchase
Short position - agree to sell
Profits on positions at maturity
Long = spot minus original futures price
Short = original futures price minus spot Key Terms for Futures Contracts

Figure 22.1 Futures Listings:

Figure 22.1 Futures Listings

Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts :

Figure 22.2 Profits to Buyers and Sellers of Futures and Option Contracts

Figure 22.3 CBOT Trading Volume in Futures Contracts :

Figure 22.3 CBOT Trading Volume in Futures Contracts

Table 22.1 Sample of Future Contracts:

Table 22.1 Sample of Future Contracts

Trading Mechanics:

Clearinghouse - acts as a party to all buyers and sellers.
Obligated to deliver or supply delivery
Closing out positions
Reversing the trade
Take or make delivery
Most trades are reversed and do not involve actual delivery
Open Interest Trading Mechanics

Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse :

Figure 22.4 A, Trading without a Clearinghouse. B, Trading with a Clearinghouse

Margin and Trading Arrangements:

Initial Margin - funds deposited to provide capital to absorb losses
Marking to Market - each day the profits or losses from the new futures price are reflected in the account.
Maintenance or variation margin - an established value below which a trader’s margin may not fall. Margin and Trading Arrangements

Margin and Trading Arrangements:

Margin call - when the maintenance margin is reached, broker will ask for additional margin funds
Convergence of Price - as maturity approaches the spot and futures price converge
Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement
Cash Settlement – some contracts are settled in cash rather than delivery of the underlying assets Margin and Trading Arrangements

Trading Strategies:

Speculation -
short - believe price will fall
long - believe price will rise
Hedging -
long hedge - protecting against a rise in price
short hedge - protecting against a fall in price Trading Strategies

Basis and Basis Risk:

Basis - the difference between the futures price and the spot price
over time the basis will likely change and will eventually converge
Basis Risk - the variability in the basis that will affect profits and/or hedging performance Basis and Basis Risk

Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15):

Figure 22.5 Hedging Revenues Using Futures, Example 22.5 (Futures Price = $67.15)

Futures Pricing:

Spot-futures parity theorem - two ways to acquire an asset for some date in the future
Purchase it now and store it
Take a long position in futures
These two strategies must have the same market determined costs Futures Pricing

Spot-Futures Parity Theorem:

Spot-Futures Parity Theorem With a perfect hedge the futures payoff is certain -- there is no risk
A perfect hedge should return the riskless rate of return
This relationship can be used to develop futures pricing relationship

Hedge Example: Section 22.4:

Hedge Example: Section 22.4 Investor owns an S&P 500 fund that has a current value equal to the index of $1,300
Assume dividends of $20 will be paid on the index at the end of the year
Assume futures contract that calls for delivery in one year is available for $1,345
Assume the investor hedges by selling or shorting one contract

Hedge Example Outcomes:

Hedge Example Outcomes Value of ST 1,305 1,345 1,405
Payoff on Short
(1,345 - ST) 40 0 -60
Dividend Income 20 20 20
Total 1,365 1,365 1,365

Rate of Return for the Hedge:

Rate of Return for the Hedge

General Spot-Futures Parity:

General Spot-Futures Parity Rearranging terms

Figure 22.6 S&P 500 Monthly Dividend Yield:

Figure 22.6 S&P 500 Monthly Dividend Yield

Arbitrage Possibilities :

Arbitrage Possibilities If spot-futures parity is not observed, then arbitrage is possible
If the futures price is too high, short the futures and acquire the stock by borrowing the money at the riskfree rate
If the futures price is too low, go long futures, short the stock and invest the proceeds at the riskfree rate

Spread Pricing: Parity for Spreads:

Spread Pricing: Parity for Spreads

Figure 22.7 Gold Futures Prices:

Figure 22.7 Gold Futures Prices

Theories of Futures Prices:

Theories of Futures Prices Expectations
Normal Backwardation
Contango

Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged:

Figure 22.8 Futures Price over Time, in the Special Case that the Expected Spot Price Remains Unchanged

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