FMP I

FMP- I
Forward and Futures
© EduPristine – www.edupristine.com
© EduPristine For FMP-I (2016)
AGENDA
 Introduction – Options, Futures and other derivatives

 Mechanics of Futures markets
 Hedging strategies using Futures
 Determination of Forward and Future Prices
 Commodity Forwards and Futures
 Fundamentals of Commodity Spot and Futures Markets
© EduPristine For FMP-I (2016) 1

Introduction to Derivatives

Introduction – Derivatives
 Derivatives are financial instruments which derive their value from an underlying asset and some
other variables such as interest rates, volatilities etc.
 Futures, forwards, options and swaps are some of the most common examples of derivatives.
 The underlying asset: It is a more basic financial instrument. Example: stocks, bonds, interest rate,
commodity etc.
 Example of a derivative: Option

• An investor owns a call option (which is a derivative) whose underlying asset is the common stock of a
company A. This option gives the investor, the right to buy the stock at a certain predefined price on or
before a future date.

Introduction – Markets
 Exchange traded Markets

• Market where individuals trade standardized
contracts that have been defined by the exchange
themselves.
• An Exchange acts as an intermediary which
facilitates a regulatory oversight and hence makes
the markets a safer place for trading.
• Chicago Board of Trade and Chicago Mercantile
Exchange are two examples.
• Open outcry system and Electronic trading.
 Over the counter markets
• There is no intermediary and no standardized
contracts; parties create their own T&C with each
other.
• Much larger than the exchange traded market in
terms of value of underlying assets (more than 4
times larger).
• Trades done between financial institutions or
between financial institutions and clients. Financial
institutions act as a market maker (quotes both bid
and ask).
Source of Graph: The Economist

Types of Investments and Purposes
 Asset types
• Financial Assets: Equity, Debt securities.
• Commodities: Gold, Copper, Crude Oil.
• Real Estate
 Let’s take an example of a financial asset (stock)
• We can buy the stock through the broker by paying the stock price.
• We can either hold the bought asset or sell it at the current market price.
• During the holding period of the stock, the dividends received goes to your pocket as the income from
the asset.
• After selling the asset, we earn a profit or loss on the asset, depending on the selling price of the
asset (stock).
 Purpose of Assets
• Investment Asset and Consumption Asset.
 Market Maker
• An individual or an institution which keeps an inventory of financial instruments or commodities who could
be asked for trading those assets. The individual or the institution then quotes a bid and an ask price on the
option.

Forward and Futures Contracts
 Futures Contracts: Agreement to buy or sell an asset for a certain price at a certain time. A futures
contract is traded on an exchange.
 Forward Contracts: Forward contracts are similar to futures except that they trade in the over-the-
counter market.
 Notation for Valuing Futures and Forward Contracts
• S0: Spot price of the asset underlying today.
• F0: Futures or forward price today.
• T: Time until delivery date (in years).
• R: Risk-free interest rate per annum, expressed in continuous compounding, for maturity T.
• Payoff of forwards and futures:
Long Short
P P
X S X S
In both Forward and Futures contracts there is an obligation to buy or sell an asset

Options
(to be covered in detail in later slides)
 Traded both on exchanges and over the counter markets.

 Call option gives the holder the right to buy the underlying asset by a specified time at a certain
price.
 Put option gives the holder a right to sell the underlying asset by a specified time at a certain
price.
 European options can be exercised on the specified date only, unlike American options which can
be exercised anytime up to the expiration date.
 One option contract is to buy/sell 100 shares in the US.
No obligation to exercise the right
Payoff of a Call Payoff of a Put
100 100
Asset Asset
Price Price
100 100

Types of traders
 Hedgers
• Uses derivatives to hedge the risks they face from volatility in the asset prices.
• Example: a company is getting a cash inflow in 3 months time in a foreign currency. It hedges its currency risk
by taking a short position in a currency forward at a particular price.
 Speculators
• Uses derivatives to bet on a particular direction of movement of the asset price.
• If a speculator believes that the spot rate of a foreign currency will be higher in 3 months than its present 3
month forward rate, he goes long on the forward. After 3 months if he is correct, he receives foreign currency
at lower rate and immediately resells it at the higher spot rate.
 Arbitrageurs
• Take offsetting positions in 2 or more instruments to lock a profit.
• Suppose that:
 The spot price of gold is US$390.
 The quoted 1-year forward price of gold is US$425.
 The 1-year US$ interest rate is 5% per annum.
 No income or storage costs for gold. Is there an arbitrage opportunity?
 Forward Rate : S = 390, T = 1, and r = 0.05 so that F = 390 (1 + 0.05) = 409.50
• Arbitrage = Buy Low – Sell High at no risk

Mechanics of Futures Market

Mechanics of future markets
Investor Broker Trader Exchange
Clearing House Member Clearing House
 Specifications of a Contract  Margins  Clearing House Margin

• Asset: If asset is a commodity, • Margin account: Investor deposits • If not the broker a clearing house
exchange specifies the asset in a certain amount of money with member has to be a member of
complete detail: grade, quality, the broker in the margin account. the clearing house.
size, shape, color, etc. • Initial margin: the initial amount • Clearing margin: Just like a margin
• Contract size: The amount of the deposited in the margin account. account with a broker, members
asset to be delivered. • Maintenance margin: Is have an account with the clearing
• Delivery arrangement: somewhat below the initial house.
place of delivery margin. The minimum amount • No maintenance margin
• Delivery month after which a margin call is sent to • Account balance to be
the investor. After margin call maintained at all times = number
investor has to top his margin of contracts *
account to the initial margin. original margin

Question: Margin Calculation (Important)
 An investor bought 1000 shares of ABC company each priced at $50. The initial margin
requirement were 60%.and the maintenance margin requirement is 25%. At what price would the
investor be getting a margin call?

Solution
 Total investment = 1000x 50 = 50,000

 Initial Margin = 60% x 50,000 = 30,000
 Maintenance margin = 25% x 50,000 = 12,500
 The investor gets a call when he/she loses 30,000 – 12,500 = 17,500
 Price of share after this loss = 50 – 17.5 = $32.50
 Hence the investor will get the margin call when the price falls to $32.50

Question: Margin Calculation (Important)
 What would be the variation margin if the stock price reduced to $10 from $50?

Solution
 When stock goes down to $10, the loss = 1000 x (50 – 10) = 40,000
 Hence margin account becomes 30,000 – 40,000 = -10,000
 Hence the investor will need to pay [(30,000 – (-10,000)] = 40,000 as variation margin

Daily settlement – An exmaple
 Trade Price $ 100 / barrel

 contract size 50 barrels
 traded future contracts: 4 Long position
 Initial Margin $ 2500 / contract i.e. $ 10000
 Maintenance margin $ 2200 / contract i.e. $ 8800
Day Initial price Settlement price Daily Gain/Loss Cumulative Gain/Loss Margin account Margin call
1-Mar $100.00 $10,000.00
1-Mar $100.00 $101.00 $1.00 $200.00 $10,200.00
2-Mar $101.00 $101.50 $0.50 $100.00 $10,300.00
3-Mar $101.50 $98.50 -$3.00 -$600.00 $9,700.00
4-Mar $98.50 $96.50 -$2.00 -$400.00 $9,300.00
5-Mar $96.50 $92.00 -$4.50 -$900.00 $8,400.00 $1,600.00
6-Mar $92.00 $91.00 -$1.00 -$200.00 $9,800.00
7-Mar $91.00 $90.20 -$0.80 -$160.00 $9,640.00
8-Mar $90.20 $93.80 $3.60 $720.00 $10,360.00
9-Mar $93.80 $80.50 -$13.30 -$2,660.00 $7,700.00 $2,300.00
10-Mar $80.50 $90.90 $10.40 $2,080.00 $12,080.00

Delivery
 Very few futures contract lead to a delivery of the underlying asset. Most are closed out early
 The period of delivery is decided by the exchange, but the exact date of delivery is specified by the
short contract holder
 Notification to deliver is given by the broker to the clearing house. The number of contracts and
the specifics of the delivery (what grade, type, quality, location, etc) is mentioned
 Exchange identifies a party with a long position to accept delivery. Typically one with the oldest
outstanding long position
 Party with the long position has to accept the delivery
 Whole delivery process from the issuance of intention to deliver to delivery takes 2–3 days
 Cash settlement is also possible. Settlement price is the spot price of the underlying on the day
opening/day close

Types of orders
 Market order: Order placed at current market rate

 Limit order: A buy limit order can only be executed at the limit price or lower, and a sell limit order can
only be executed at the limit price or higher
 Stop Order: A stop order activates a market order to either buy or sell a stock once the price of the stock
reaches a specified price, known as the stop price. As the stop price is surpassed, the order becomes a
market order i.e. as soon as the stock surpasses the stop price, it is bought or sold at the market price
 Stop Limit order: A stop limit order activates a limit order to either buy or sell a stock once the price of
the stock reaches a specified price. It has the same difference with stop order as the difference between
a limit order and a market order. Example: A stock is trading at $40, an investor places a stop limit order
with stop price $42 and limit price $42.80. As the stock crosses $42 the limit order is activated
 Market-if-touched order: It is similar to stop order but the buy and sell happens the opposite way. In
case of MIT buy order, the market order is activated when a lower level price is met. While in stop order
the market order is activated when a higher level price is met
 Discretionary order: A market order whose execution may be delayed at the broker’s discretion in order
to get a better price
 Time-of-day order: An order which is executed at a particular period of day
 Open order: An order which is in effect until executed or until the end of the trading in the
particular contract
 Fill-or-kill order: An order that must be executed immediately or not at all

Reading the newspaper*
Precious Metals  Settlement price: this price is used for margin call
Gold Comex (100 Troy oz; $/troy oz) calculations at end of trading day
Sett Day’s
High Low
Vol 0 int  Change : -$8.5 per troy ounce. Hence, total of
price chge ’000s ’000s 100*$8.5=$850 reduction in margin account balance
Dec 738.7 -8.5 748.5 736.7 111.8 300.3  Open interest: total number of contracts outstanding
Feb 745.0 -8.6 754.8 743.5 6.00 31.86 with the exchange. It is the total number of long
Total 123.7 449.5 positions / the total number of short positions. It is
one trading day older than the prices’ day
Time Trading Activity Open Interest
Jan 1 A buys 1 option and B sells 1 option contract 1
Jan 2 C buys 5 option and D sells 5 option contract 6
Jan 3 A sells his 1 option and D buys 1 options contract 5
Jan 4 E buys 5 options from C who sells 5 options contracts 5
 On January 1, A buys an option, which leaves an open interest and also creates trading volume of 1
 On January 2, C and D create trading volume of 5 and there are also five more options left open
 On January 3, A and D take offsetting positions, open interest is reduced by 1 and trading volume is 1
 On January 4, E simply replaces C and open interest does not change, trading volume increased by 5

Hedging Strategies Using Futures

Futures vs. Cash (spot) position
 Generally, there is a high correlation in price movements between the futures market and the
cash market.
 Futures position acts as a substitute for later cash transaction.
 Hedgers generally take equal and opposite position in cash and futures.

Hedging using futures
 Hedge is a position established to minimize the exposure to the unwanted risks.

 Hedge can be either a short hedge or a long hedge.
 Short hedge (selling hedge): is a hedge in which an investors takes a short position in a contract
• Example: A farmer expects to harvest 1000 bushels of corn in October. Currently in July the price of corn is
$2.5 per bushel. The farmer faces the risk of price of corn decreasing in 3 months time (i.e. October).
Available 3 months future position in corn trades at $2.3 per bushel.
• In the above example, the cash price (spot) is $2.5, futures price is $2.3.
• Farmer has a naturally long position in the cash market (i.e. in October the farmer would be having 1000
bushels of corn).
• To hedge his position, the farmer places a short hedge (selling hedge), to sell corn bushels in at $2.3 per
bushel in the month of October.
 Long hedge (buying hedge) Is a hedge in which an investors takes a long position in a contract
• Example: A corn flakes producer, Kellogs, needs 1000 bushels of corn in August, to produce corn flakes for
future demand. Currently, in July, the price of corn is $2.5 per bushel. Kellogs is concerned about the
increase in price of corn in one months time. Available 1 month corn futures position trades at $2.55 per
bushel.
• The cash price is $2.5/bushel, and the 1 month futures price is $2.55
• Kellogs has a naturally short position in the cash market, and thus places a long hedhe (buying hedge).

Is hedging always good?
 Hedging and shareholders: Shareholders can hedge the risk themselves. Companies don’t need
to. But do the shareholders have as much information as the companies? What about transaction
costs and commissions? Companies carry out high volume transactions hence cost of hedge
is lower.
 Hedging and competitors: What if the price of hen food was reduced as the hen producers union
pressed the suppliers to reduce their prices. HP‘s profits would rise as he had locked his selling
price and the raw material prices went down. For others the change in profits would be 0. What if
the raw material prices went up for some reason and the union decided to raise their selling
prices in the market proportionately. HP’s profit would reduce while others profit remain the
same. Hedging actually is causing fluctuation in profits!!
 Any other reasons you can think of?

Hedging in a practical world (Basis Risk)
 Not always does the futures contract date be the same as the
date the asset is to be bought or sold. Future
 What if the farmer didn’t know when his corn produce would be Price
ready for sale? Spot Price

 What if he doesn’t get a long contract that will close his position
just one day before the closing of his short contract?
Time
 What if there is no contract for the type/grade of corn the
farmer is selling?
This is basis risk
 Basis = spot price of asset – futures price contract Future
• Basis = 0 when spot price = futures price Price
• b1 = S1 - F1 and b2 = S2 - F2
Future
• Farmer pay off when he sells his corn: S2 + F1 - F2 or F1 + b2 Price
• In a typical transaction, F1 is known but b2 is not known at time
t1  b2 is the basis Time
Expect 2 questions directly based on the 4 factors that incorporate basis risk

Question
 Imagine a stack-and-roll hedge of monthly commodity deliveries that you continue for the next
five years. Assume the hedge ratio is adjusted to take into effect the mistiming of cash flows but is
not adjusted for the basis risk of the hedge. In which of the following situations is your calendar
basis risk likely to be greatest? (FRM 2008 Sample Paper)
A. Stack and roll in the front month in oil futures
B. Stack and roll in the 12-month contract in natural gas futures
C. Stack and roll in the 3-year contract in gold futures
D. All four situations will have the same basis risk

Solution
 A.
• The oil term structure is highly volatile at the short end, making a front-month stack-and roll hedge heavily
exposed to basis fluctuations. In natural gas, much of the movement occurs at the front end, so the 12-month
contract won’t move much. In gold, the term structure rarely moves and won’t begin to compare with oil and
gas.

Choice of contracts
 Choose a delivery month that is as close as possible to, but later than end of life of the hedge
because:
• The futures prices are quite volatile during the delivery month.
 When there is no futures contract on the asset being hedged, choose the contract whose futures
price is most highly correlated with the asset price.
 In such cases the proportion of the exposure that should optimally be cross hedged
 S
• Optimal Hedge Ratio: h 
 
 F
 Where
• σS is the standard deviation of δS, the change in the spot price during the hedging period.
• σF is the standard deviation of δF, the change in the futures price during the hedging period.
• ρ is the coefficient of correlation between δS and δF.

Optimal number of contracts
 The optimal number of contracts (N*) to hedge a portfolio consisting of NA number of units and
where Qf is the total number of futures being used for hedging
h * NA
N*
Qf
 In the case of a stock index the similar logic follows. If P is the value of the portfolio of stocks held
by an investor and A is the current value of the stocks lying under one futures contract then the
optimal hedge ratio, N*, should be equal to P / A.
 In practical cases investors don’t typically have portfolios that trace the index. Hence the concept
of β comes into play. Beta (β) is a measure of a stock's volatility in relation to the market.
 In order to change the beta (β) of the portfolio to (β*), we need to long or short the (N*) number
of contracts depending on the sign of (N*)
P
N* β
A
P
N *  (  * - )
A
Negative sign of (N*) indicates shorting the contracts

Question
 If you have a portfolio of $500,000 which mirrors S&P 500. Each S&P 500 contract is $250 times
the index when the index is at 500. Calculate the number of contracts to be hedged?

Solution
 A = 250 * 500 = 125,000. Then N* = 500,000/125,000 = 4 contracts should be shorted for

the hedge

Question
 The current value of the S&P 500 index is 1,457, and each S&P futures contract is for delivery of
US$250 times the index. A long‐only equity portfolio with market value of US$300,100,000 has
beta of 1.1. To reduce the portfolio beta to 0.75, how many S&P futures contract should you sell?
(FRM Sample Paper 2009)

Solution
 [(0.75 – 1.1)/ 1] * [300,100,000 / {250 * 1,457}] = ‐288.36  sell 288 contracts

Rolling forward a hedge
 We can use a series of futures contracts to increase the life of a hedge

 Each time we switch from 1 futures contract to another we incur a type of basis risk
 Strip Hedge
 Stack and Roll Hedge
Expect 2 questions based on Stack and Roll hedge or MG case.

Please refer original case study for Stack and Roll Hedge

Determination of Forward and Futures Prices

Consumption vs. Investment Assets
 Investment assets
• Assets held for investment purposes by significant numbers of investors.
(examples: stocks, bonds, gold, silver)
 Consumption assets:
• Assets held primarily for consumption (examples: copper, oil and pork bellies)
 Gambling – Short Selling an example
• Short selling involves selling securities that are not owned
 Suppose an investor short sells 500 IBM shares, the broker will borrow the securities from another client and sells
them in the market in the usual way
 At some stage the investor will close the position by purchasing 500 IBM shares. The investor takes the profit if the
stock prices have declined , else vice versa
 Short Squeezed: If anytime the broker runs out of shares to borrow, the investor is short squeezed and forced to
close his position immediately

Forwards vs. Futures contracts
 Forwards  Futures
• Not traded on exchanges • Traded on exchanges
• Are private agreements between two parties • Standard contracts
and are not as rigid in their stated terms and • Clearing house and daily mark to market
conditions reduces credit risk
• Credit risk is high • Settlement can occur over a range of dates
• High customization • Usually closed out before maturity and hardly
• Settlement at the end of contract and on a any deliveries happen
specific date
• Mostly used by hedgers that want to remove the
volatility of the underlying, hence delivery/ cash
settlement usually takes place

Determination of Forward Price
 The price of a forwards contract is given by the equation below:

• F0 = S0ert in the case of continuously compounded risk free interest rate, r
• F0 = S0(1+r )t in the case of annual risk free interest rate, r
• Where:
 F0: forward price
 S0: Spot price
 t: time of the contract
 Known income from underlying
• If the underlying asset on which the forward contract is entered into provides an income with a present
value, I, then the forward contract would be valued as:
 F0 = (S0 – I )ert
 Known yield from underlying
• If the underlying asset on which the forward contract is entered into provides a continuously compounded
yield, q, then the forward contract would be valued as:
 F0 = S0e(r-q)t
 q: continuously % of return on the asset divided by the total asset price

Value of forward contracts
 At the time of entering into a forward contract, long or short, the value of the forward is zero
 This is because the delivery price (K) of the asset and the forward price today (F0) remains the
same
 The value of the forward is basically the present value of the difference in the delivery price and
the forward price
 Value of a long forward, f, is given by the PV of the pay off at time T:
• ƒ = (F0 – K )e–rT
 K is fixed in the contract, while F0 keeps changing on an everyday basis
 For continuous dividend yielding underlying

• f = S0e-qt – Ke-rt
 For discrete dividend paying stock
• f = S0 – I – Ke-rt
 Index futures: A stock index can be considered as an asset that pays dividends and the dividends
paid are the dividends from the underlying stocks in the index
 If q is the dividend yield rate then the futures price is given as:
• F0= S0e(r-q)t
 Index Arbitrage
• When F0 > S0e(r-q)T an arbitrageur buys the stocks underlying the index and sells futures
• When F0 < S0e(r-q)T an arbitrageur buys futures and shorts or sells the stocks underlying the index

Forward vs. Futures Prices
 Forward and futures prices are usually assumed to be the same. When interest rates are uncertain,
they are slightly different in theory
 A strong positive correlation between interest rates and the asset price implies the futures price is
slightly higher than the forward price
 A strong negative correlation implies the reverse

Futures and Forwards on Currencies
 Interest rate Parity

( rbc  r fc )T
F0  S 0 e
 Formula to remember:
• If Spot rate is given in USD/INR terms then take American Risk-free rate as the first rate
• In other words, individual who is interested in USD/INR rates would be an American (Indian will always think
in Rupees not dollars!!), which implies foreign currency (rf) in his case would be rINR
FUSD  SUSD e( rUSD rINR )T

INR INR

Question
 The forward rate of a 3-month EUR/USD foreign exchange contract is 1.1565 USD per EUR. USD
LIBOR is 4% and EUR LIBOR is 2%. The spot USD per EUR exchange rate is?

Solution
 F0 = S0 e(r-rf)t
 1.1565 e-(.04- .02).25 = 1.1507

Question
 Assume that the current 1-year forward exchange rate is 1.200 USD per EUR. An American bank
pays 2.4% annual interest rate on a 1-year deposit and a 4.0% annual interest rate on a 3-year USD
deposit. A European bank pays a 1.5% annual interest rate for a 1-year deposit and a 2.0% annual
interest rate for a 3-year EUR deposit. The forward exchange rate of USD per EUR for exchange
three years from today is closest to:

Solution
 The 2 year forward rate in US =  [(1.04)3 / 1.024] – 1 = 4.81%

 The 2 year forward rate in Europe =  [(1.02)3 / 1.015] – 1 = 2.25%
 The forward exchange rate of USD per EUR for exchange three years from today:
• 1.2 *(1.04812) / (1.02252) = 1.261

Question
 The two-year risk-free rate in the United Kingdom is 8% per annum, continuously compounded.
The two-year risk-free rate in France is 5% per annum, continuously compounded. The current
French Franc to the GBP currency exchange rate is 1GBP = 0.75 French Franc.
 What is the two-year forward price of one unit of the GBP in terms of the French Franc so that no
arbitrage opportunity exists?
A. 0.578
B. 0.706
C. 0.796
D. 0.973

Solution
 B. Ans = 0.75*e(0.05-0.08)*2 = 0.706

Question
 A bank has a USD 50,000,000 portfolio available for investing. The cost of funds for the USD
50,000,000 is 4.5%. The bank lends 50% of the assets to domestic customers at an average loan
rate of 6.25%. The rest of the portfolio is lent to UK clients at 7%. The current exchange rate is
USD1.642/GBP. At the same time, the bank sells a forward contract equal to the expected receipts
one year from now. The forward rate is USD1.58/GBP. The weighted average return to the bank on
its investments is closest to?

Solution
 The return from UK customers, $25,000,000/1.642 = GBP 15,225,335* 1.07 = GBP 16,291,108
 The bank sells a forward contract: GBP 16,291,108*1.58 = USD 25,739,951
 Earnings (USD 25,739,951 – 25,000,000) / 25,000,000 = 2.96%
 Weighted average return = 6.25%*0.5 + 2.96%*0.5 = 4.61%

Question
 Given the following:

• Current spot CHF/USD rate: 1.3680 (CHF1.3680 = USD1)
• 3-month USD interest rates: 1.05% ; 3-month Swiss interest rates: 0.35%
 A currency trader notices that the 3-month forward price is USD / CHF 0.7350. In order to
arbitrage, the trader should?

Solution
 The spot is quoted in terms of Swiss Francs per USD. To convert this into USD per Swiss Franc, we
get: 1/1.3680 = 0.7310. The theoretical futures price = 0.7310 * exp((0.0105 – 0.0035) * 0.25) =
0.7323. Therefore, the quoted futures price is too high. Thus, one should sell the overvalued CHF
futures contract.
 In order to arbitrage, one would do the following:
• Borrow USD 0.7310 * exp((-0.0035)*0.25) = USD 0.7304 for 3 months
• Buy spot exp((-0.0035)*0.25) = CHF0.9991, invest at 0.35% for 3 months
• Short a futures contract on CHF1
 At maturity,
• Pay back 0.7304 * exp((0.0105) * 0.25) = USD 0.7323
• Receive 0.9991 * exp((0.0035) * 0.25) = CHF 1
• Delivers CHF 1 on the futures contract, receives USD 0.7350
• An arbitrage profit of USD0.7350 – USD0.7323 = USD 0.0027 would be realized in 3 months’ time

Commodity Futures

Futures on Consumption Assets
 F0 ≤ S0 e(r+u)T
• Where u is the storage cost per unit time as a percent of the asset value
 Alternatively, F0 ≤ (S0 + U )erT
• Where U is the present value of the storage costs

Question
 The current spot price for cotton is $0.325 per pound. The annual risk-free rate is 3.0%, and the
cost to store and insure cotton is $0.002 per pound per month. A 3 month futures contract for
cotton is trading at $0.3368 per pound. Is there an arbitrage opportunity available, and if so, how
should an investor take advantage of it?

Solution
 The Forward price = 0.325e0.03*0.25 + (0.002+ 0.002*1.0025+ 0.002*1.0025^2) = 0.3335; Yes; the
investor should sell the futures contract, borrow at the risk-free rate, and buy the
spot asset.

Question
 The spot rate for a commodity is $19. The annual lease rate for the commodity is 5%. The
appropriate continuously compounding annual risk-free rate is 6.5%. What is the 3-month
commodity forward price?

Solution
 F0 = S0 e(r- )t = $19.07

The Cost of Carry
 The cost of carry, c, is the storage cost plus the interest costs less the income earned
 For an investment asset F0 = S0ecT
 For a consumption asset F0 ≤ S0ecT
 The convenience yield on the consumption asset, y, is defined so that: F0 = S0 e(c–y )T

Futures Prices

Futures price
 In a treasury futures contract the price of the bond is not easy to deliver because the cheapest to
deliver bond is not known
 However, if the cheapest to deliver bond and its delivery date is known we can call upon the
equation which considers discreet payouts from an underlying and can be given as below:
• F0 = (S0-I) ert
Eurodollar Futures:
 A Eurodollar is a dollar deposited in a foreign bank/US bank outside the United States
 Eurodollar futures are futures on the 3-month Eurodollar deposit rate (same as 3-month LIBOR
rate)
 Long position => agrees to give a loan at the determined price
 One contract is on the rate earned on $1 million
 A change of one basis point or 0.01 in a Eurodollar futures quote corresponds to a contract price
change of $25 (1mm * 0.01% * 90/360)
 When it expires (on the third Wednesday of the delivery month), final settlement price is 100
minus actual three month deposit rate.
 Contract Price = 10,000*[100 – 0.25*( 100 – Q)]
• Q = Quoted Price

Question
 Suppose you buy (take a long position in) a Eurodollar futures contract on November -1
 The contract expires on December-21 Date Quote
 The prices are as shown Nov 1 97.12
 How much do you gain or lose Nov 2 97.23
• On the first day Nov 3 96.98
• On the second day
– –
• Over the whole time until expiration?
Dec 21 97.42

Solution
 Day 1: increase by 11 basis points, hence gain = 11*25 = $275

Date Quote
 Day 2: decrease by 25 basis points, hence loss = 25*25= $625
Nov 1 97.12
 Until expiration: increase by 30 basis points, gain = 30*25 = $750
Nov 2 97.23
Nov 3 96.98
– –
Dec 21 97.42

Eurodollar futures and forwards
 In a Eurodollar futures contract that locks in an interest rate between times T1 and T2 the interest
rate is locked in at time T1 and the settlement is made at time T1
 In an FRA which also locks in an interest rate between times T1 and T2, the final settlement is
made at time T2
 Difference between Eurodollar futures and FRA
• In an FRA the payoff is equal to the difference in the forward interest rate and the realized interest rate
• The settlement is at time T1 for the E-futures contract while its at time T2 for the forward contract
• Analysts adjust forward rates with the following equation:
1
Forward rate  futuresrate   2T1T2
2
  is the standard deviation of the change in the short term interest rate in 1 year

Normal Backwardation and Contango
 When the futures contracts have substantial time to maturity then the futures prices are different
from the expected future spot prices
 When futures prices are greater than the expected future spot prices then the scenario is termed
as contango
 When futures prices are lower than the expected future spot prices then the scenario is termed as
normal backwardation
 Normal futures curve: When futures prices are greater for greater maturity
 Inverted futures curve: When futures prices are lower for greater maturity. (example: orange juice,
because its value depreciates with time)

Commodity Spreads

Commodity Spreads
 Commodity Spread: is a result of a commodity that is used in the production process. Let’s take an
example of mustard seeds which can be used to prepare mustard oil which sells at a higher price
than mustard seeds. This difference of prices between the raw and processed commodity is the
commodity spread
 Commonly used Commodity spreads:
Commodity Spreads
Crack Spread Crush Spread

->Long (short) position in ->Long (Short) position in
Crude oil and short (long) Soybeans and short (long) position in
position in heating oil and gasoline soybean meal and soybean oil

Some Important Commodities and their Properties
Commodity Demand Production Property Futures Price

Constant
Seasonal Interest and Storage Cost Increases until harvest time
Corn throughout
Production determines the price and then drops sharply
the year
Produced
Too expensive to store / Futures price rise steadily
Natural Gas Seasonal Demand throughout
Demand peaks in winter in fall months
the year
Produced Oil prices are stable in absence
Constant world- Can be cheaply
Oil throughout of short-run
wide demand transported
the year supply and demand
Futures prices of electricity is
Price is determined by the demand and
Electricity Non-storable more volatile than financial
supply at a given point in time
futures

Five Minute Recap
Key Terms to Remember: Eurodollar Futures: Cost of Carry Model:

1
 Initial, Maintenance and variation Margin  Futures rate ( FRA)   2T1T2  Investment asset F0 = S0ecT
2
 Contango and Backwardation  Consumption asset F0 ≤ S0ecT
 Normal Contango and Normal Backwardation Basis Risk:  Convenience yield F0 = S0 e(c–y )T
 Commodity Spreads  Basis = spot price of asset – futures price
contract
Forwards on Currencies: Index Futures: Commodity Spreads: Rolling forward a hedge:

( rbc  r fc )T  F0= S0 e(r-q)t  Crack Spread  Strip Hedge
F0  S 0 e
 Crush Spread  Stack and Roll Hedge
Optimal Hedge Ratio: Optimal number of contracts: Future Price: Interest Rate Parity:
 S
h   N *  (  * - )
P  F0 = S0 erT FUSD  S USD e( rUSD  rINR )T
 F A  F0 = S0 (1+r )T INR INR
Payoff of a Call Payoff of a Put Optimal contract to hedge a Types of Orders:

portfolio:  Market order  Discretionary
h * NA
N*  Limit order order
Qf  Stop Order  Time-of-day
100 100 order
 Stop Limit
Types of traders: order:  Open order
 Hedgers  Arbitrageurs  Market-if-  Fill-or-kill order
 Speculators touched order
100 Asset 100 Asset
Price Price Margins:  Maintains Margin
 Initial Margin  Variation Margin
F4,5(forward rate) = (R5T5 – R4T4)/(T5 – T4)

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FMP I

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FMP- I

Forward and Futures

 Introduction – Options, Futures and other derivatives

© EduPristine For FMP-I (2016) 1

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 Example of a derivative: Option

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 Exchange traded Markets

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 Traded both on exchanges and over the counter markets.

Payoff of a Call Payoff of a Put

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Investor Broker Trader Exchange

Clearing House Member Clearing House

 Specifications of a Contract  Margins  Clearing House Margin

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 Total investment = 1000x 50 = 50,000

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 Trade Price $ 100 / barrel

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 Market order: Order placed at current market rate

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 Hedge is a position established to minimize the exposure to the unwanted risks.

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 Any other reasons you can think of?

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ready for sale? Spot Price

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 A = 250 * 500 = 125,000. Then N* = 500,000/125,000 = 4 contracts should be shorted for

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 [(0.75 – 1.1)/ 1] * [300,100,000 / {250 * 1,457}] = ‐288.36  sell 288 contracts

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 We can use a series of futures contracts to increase the life of a hedge

Expect 2 questions based on Stack and Roll hedge or MG case.

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 The price of a forwards contract is given by the equation below:

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 For continuous dividend yielding underlying

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 Interest rate Parity

FUSD  SUSD e( rUSD rINR )T

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 B. Ans = 0.75e(0.05-0.08)2 = 0.706