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Main issues
Forwards and Futures
1 Forward Contracts
Denition: A forward contract is a commitment to purchase at a
future date a given amount of a commodity or an asset at a price
agreed on today.
agreement settlement
-
0 T time
The price xed now for future exchange is the forward price.
custom tailored
Fall 2006
c J. Wang 15.401 Lecture Notes
10-2 Forwards and Futures Chapter 10
2 Futures Contracts
Forward contracts have two limitations:
(a) illiquidity
Standardized contracts:
(1) underlying commodity or asset
(2) quantity
(3) maturity.
Traded on exchanges.
A Forward Contract
A Futures Contract
Fall 2006
c J. Wang 15.401 Lecture Notes
10-4 Forwards and Futures Chapter 10
a loss of $800.
F H.
Fall 2006
c J. Wang 15.401 Lecture Notes
10-6 Forwards and Futures Chapter 10
3.1 Commodities
1. Gold.
Easy to storenegligible cost of storage.
No dividends or benets.
Two ways to buy gold for T :
Buy now for S0 and hold until T .
Buy forward, pay F and take delivery at T .
No-arbitrage requires that
F = S0(1 + rF)T H.
2. Oil.
Costly to store.
Additional benets, convenience yield, for holding physical
commodity (over holding futures).
Not held for long-term investment (unlike gold), but mostly
held for future use.
Let the percentage holding cost be c and convenience yield be
y . We have
F = S0 [1 + rF (y c)]T
= S0(1 + rF y)T
H
where
y = y c
is the net convenience yield.
Fall 2006
c J. Wang 15.401 Lecture Notes
10-8 Forwards and Futures Chapter 10
1. Contango means:
(a) spot prices are lower than futures prices, and/or
(b) prices for near maturities are lower than for distant.
2. Backwardation means:
(a) spot prices are higher than futures prices, and/or
(b) prices for near maturities are higher than for distant.
y rF = y c rF > 0.
3.2 Financials
Fall 2006
c J. Wang 15.401 Lecture Notes
10-10 Forwards and Futures Chapter 10
Note:
Since the underlying asset is a portfolio in the case of index
futures, trading in the futures market is easier than trading
in cash market.
Thus, futures prices may react quicker to macro-economic
news than the index itself.
Index futures are very useful to market makers, investment
bankers, stock portfolio managers:
hedging market risk in block purchases & underwriting
creating synthetic index fund
portfolio insurance.
Fall 2006
c J. Wang 15.401 Lecture Notes
10-12 Forwards and Futures Chapter 10
Thus, in this case you know today exactly what you will receive 5
months from now. That is, the hedge is perfect.
Fall 2006
c J. Wang 15.401 Lecture Notes
10-14 Forwards and Futures Chapter 10
One problem with using forwards to hedge is that they are illiquid.
We should short the futures: If interest rate goes up, bond prices
go down but a gain is made on the short position of futures.
Match duration:
Thus:
10, 000, 000 6.80
(# of contracts) = = 75.48.
93, 062.50 9.68
Fall 2006
c J. Wang 15.401 Lecture Notes
10-16 Forwards and Futures Chapter 10
Maturity
Contract size
Underlying asset.
5 Homework
Readings:
Assignments:
Problem Set 6
Fall 2006
c J. Wang 15.401 Lecture Notes