DM Introduction

FUTURES MARKET: MEANING, PARTIES, TRADING PROCEDURE, HEDGING STRATEGIES, VALUATION, SEBI GUIDELINES

Birth of futures
Forward contracts were useful, but only up to a point. They didnt eliminate the risk of default among the parties involved in the trade. For example, merchants might default on the forward agreements if they found the same product cheaper elsewhere, leaving farmers with the goods and no buyers.

Conversely, farmers could also default if prices went up dramatically before the forward contract delivery date, and they could sell to someone else at a much higher price.

Therefore, a standardized contract was required to address this issue.

The concept of futures contract

A legally binding, standardized agreement to buy or sell a standardized commodity, specifying quantity and quality at a set price on a future date.
A great advantage of standardized contracts was that they were easy to trade. As a result, the contracts usually changed hands many times before their specified delivery dates. Many people who never intended to make or take delivery of a commodity began to actively engage in buying and selling futures contracts.

Why? They were speculating taking a chance that as market conditions changed they would be able to buy or sell the contracts at a profit.
The ability to eliminate a position on a contract by buying or selling it before the delivery date called offsetting is a key feature of futures trading.

The clearinghouse
Clearing house becomes sellers buyer and buyers seller. Let us say, buyer and seller agree on a $4 per bushel (min 5000 bushels) contract wheat futures contract
Promise to pay $20,000 Buyer Promise to deliver 5, 000 bushels Seller

The house becomes an intermediary to the futures contract

Promise to pay $20,000 Promise to pay $20,000

Buyer

Clearinghouse

Seller

Promise to deliver 5, 000 bushels

Promise to deliver 5, 000 bushels

Reversing trades (offsetting)

Suppose today the price of the futures is $3.95 and next day, the buyer finds that people are paying $4.15 per bushel for wheat. If B believes that the price of wheat will not go any higher, then B might sell a wheat futures contract for $4.15 to someone else.

In this situation, B has made a reversing trade.

Margin requirements for a futures contract (buyer)

Day Price of wheat Event Amount Equity in account If maintenance margin were not required 1 2 3 4 4 4.10 3.95 4.15 Deposit initial margin Mark to market Mark to market Mark to market 1000 500 -750 1000 1000 1500 750 1750

With required maintenance margin 1 2 4 4.10 Deposit initial margin Mark to market Buyer withdraws cash 3 3.95 Mark to market Buyer deposits cash 4 4.15 Mark to market Reversing trade and withdrawal of cash 1000 500 -500 -750 750 1000 -2000 1000 1500 1000 250 1000 2000 0

Futures

Since B is involved in two wheat contracts, one as a seller and one as a buyer, B is obligated to deliver 5000 bushels to clearing house and clearing house in turn is required to deliver it back to B.
The moment B offsets his positions, clearing house will immediately cancel both of them, and B will be able to withdraw $2000 from his account.

Methods to protect clearinghouse against default of buyers/sellers

The procedures that protect clearinghouse from potential losses due to noncompliance of the buyer or seller are:
Impose initial margin requirements on both buyers and sellers Mark to market the accounts of buyers and sellers every day Impose daily maintenance margin requirements on both buyers and sellers.

A performance bond is a deposit to cover losses you may incur on a futures contract as it is marked-to-market. A maintenance performance bond is a minimum amount of money (a lesser amount than the initial performance bond) that must be maintained on deposit in your account. A performance bond call is a demand for an additional deposit to bring your account up to the initial performance bond level.

Initial margin (initial performance bond)

In stock trading, margin refers to a partial deposit you put up with your broker to purchase securities, while borrowing the remaining amount (typically half) from the broker (expecting to pay interest).

In futures, this down payment is actually a good faith deposit you pay to indicate that you will be able to ensure fulfillment of the contract.

Futures contracts require an initial performance bond in an amount determined by the exchange itself. This amount is roughly 5% to 15% of the total purchase price of the futures contract. This margin covers only a part of the protection against the total loss in the case of default. Therefore, the use of marking to market coupled with a maintenance margin requirement provides the requisite amount of additional protection.

Marked-to-the-market
At the end of the trading day your position is marked-to-the-market. That is, the clearing house will settle your account on a cash basis. Money will be added to your performance bond balance if your position has made a profit that day. If youve sustained a loss that day, money is deducted from your performance bond account. This rebalancing occurs each day after the close of trading.

Performance bond call

If your position has lost money and the balance in the performance bond account has fallen below the maintenance level, a performance bond call will be issued. That means you have to put in more money to bring the account up to the initial performance bond level.

Hedging with futures

The difference between the cash price and the futures price is called basis. The basis changes during the life of the futures contract. It tends to narrow as contract maturity approaches.

That is, the futures price moves closer to the cash price during the delivery month.

Long Hedge
Suppose on June 1, Ms. Deepa realizes she needs to purchase 110,000 pieces of wood planks on September 1.

Todays cash price for wood planks is $300 per 1000 board feet ($300/MBF). She observes that September Lumber futures are currently trading at $305/MBF.
She also knows that historically the futures price in September tends to be about $5/MBF higher than the cash price. So Deepa figures that by buying a September Lumber futures contract in June at $305, she is locking in a price of about $300.

Cash market

Futures market

June 1

Needs to buy wood planks in September for $300/MBF to make desired profit.
Cash price rises to $315/MBF. Deepa buys lumber for $315/MBF. Deepa pays $15/MBF more for lumber than she wanted to.

Buys (goes long) one September Lumber futures contract at $305/MBF.

Deepa sells her September Lumber contract at $320/MBF.

Sep 1

Results

However, she gains $15/MBF when she sells the futures contract.

Cash market

Futures market

June 1

$300/MBF X 110 = $33,000

$305/MBF X 110 = $33,550

Sep 1

$315/MBF X 110 = $34,650

$320/MBF X 110 = $35,200

Results

Higher cost in cash market: Spent $1,650 more

Net profit in futures market: Gained $1,650

Risk Management
The futures market is specifically designed for hedgers, or commercial participants, to minimize their chance of loss due to adverse price moves in the cash market. Hedgers are firms or individuals whose businesses include the same or similar commodities as those traded in the futures markets. The hedger attempts to reduce the risk of price uncertainty through the purchase or sale of futures contracts. By entering into futures contracts, hedgers can effectively lock in a price that will make their revenues or costs more predictable. This is risk management.

By now you should be wondering how the hedger can rid himself of unwanted risk.

The risk cannot just disappear. Someone has to take that risk. Who are these risk takers? Theyre known as speculators.

Principles of futures contract pricing

There are three main theories of future pricing

The expectations hypothesis Normal backwardation A full carrying charge market

1. The expectations hypothesis

Hypothesis: The futures price for a commodity is what the marketplace expects the cash price to be when the delivery month arrives. The expectation hypothesis is a good predictor because it provides an important source of information about what the future price is likely to be. It works like a price discovery mechanism.

We know that there is a relationship between the price of the commodity in the cash market and price of that commodity in the futures market. The futures market price should reflect the storage cost of that commodity unto that future date plus the cash price of that commodity today and any other costs. If futures price is more than this price (= cash price + storage cost + other costs) then there is a possibility of arbitrage.

One will purchase the commodity today, store it and at the same time short a futures contract to deliver it on the futures date.

Since there is a difference in prices, there is a scope for arbitrage.

Basis, Repo rate

Basis = current spot price corresponding future price
Future price here is the purchase price stated in the futures contract. Spot price is the price of a good for immediate delivery. Open interest is the number of futures contracts for which delivery is currently obligated.

Repo Rate
The repo rate is the finance charges faced by traders. The repo rate is the interest rate on repurchase agreements.

A Repurchase Agreement
An agreement where a person sells securities at one point in time with the understanding that he/she will repurchase the security at a certain price at a later time.

Arbitrage
An Arbitrageur attempts to exploit any discrepancies in price between the futures and cash markets.

An academic arbitrage is a risk-free transaction consisting of purchasing an asset at one price and simultaneously selling it that same asset at a higher price, generating a profit on the difference.

Example: riskless arbitrage scenario for INFOSYS stock trading on the NSE and BSE.

Assumptions:
Perfect futures market No taxes No transactions costs Commodity can be sold short

Price Exchange Arbitrageur Buys INFY Arbitrageur Sells INFY Riskless Profit (1105) BSE 1110 NSE 5

How Trading affects open interest

How Trading Affects Open Interest
Time t=0 t=1 t=2 t=3 Action Trading opens for the popular widget contract. Trader A buys and Trader B sells 1 widget contract. Trader C buys and Trader D sells 3 widget contracts. Trader A sells and Trader D buys 1 widget contract. (Trader A has offset 1 contract and is out of the market. Trader D has offset 1 contract and is now short 2 contracts.) Trader C sells and Trader E buys 1 widget contract. Trader B C D E All Traders Long Position 2 2 1 3 3 Open Interest 0 1 4 3

t=4 Ending Positions

3 Short Position 1

Contango and Backwardation

Normally, the futures price exceeds the spot price; this market is called contango. If the futures price is less than the spot price, this is called backwardation, or an inverted market. As the gap between the futures price and spot narrows, we say that the basis is strengthened.

2. Normal Backwordation
A hedger (for example, a farmer) who is selling a futures contract is trying to lock in the price of the commodity in future. i.e. the hedger is trying to reduce the risk, but this risk has to be borne by somebody i.e. speculators. Now question is if the future price equals the spot price + storage costs + other costs exactly, what the speculator will earn by bearing the risk? Therefore, the speculator will agree to that future price where he expects that the spot price on the delivery date will be higher than futures price.

This is called normal backwardation.

3. A full carrying charge market

A full carrying charge market occurs when futures prices reflect the cost of storing and financing (borrowing) the commodity until the delivery month.

In the world of certainty, the futures price is equal to the current spot price plus the carrying charges until the delivery month.

The concept of full-carry market

To the extent that markets adhere to the following equations markets are said to be at full carry:

F 0 , t S 0 (1 C 0 , t ) F 0 , d F 0 , n (1 Cn , d )
If the futures price is higher than that specified by above equations, the market is said to be above full carry. If the futures price is below that specified by the above equations, the market is said to be below full carry.

To determine if a market is at full carry, consider the following example:

Suppose that:

September Gold December Gold Bankers Rate

$410.20 $417.90 7.8%

Step 1: compute the annualized percentage difference between two futures contracts.
AD

(F ) F
0, d 0. N

12 M 1

Where
AD = Annualized percentage difference M = Number of months between the maturity of the contracts. futures

12 $417.90 3 AD 1 $410.20

AD 0.0772
Step 2: compare the annualized difference to the interest rate in the market. The gold market is almost always at full carry. Other markets can diverge substantially from full carry.

Market features that promote full-carry market

Ease of Short Selling
To the extent that it is easy to short sell a commodity, the market will become closer to full carry. Difficulties in short selling will move a market away from full carry. Selling short of physical goods like wheat is more difficult, while selling short of financial assets like Eurodollars is much easier. For this reason, markets for financial assets tend to be closer to full carry than markets for physical assets.

Large Supply
If the supply of an asset is large relative to its consumption, the market will tend to be closer to full carry. If the supply of an asset is low relative to its consumption, the market will tend to be further away from full carry.

Non-Seasonal Production
To the extent that production of a crop is seasonal, temporary imbalances between supply and demand can occur. In this case, prices can vary widely. Example: in North America, wheat harvest occurs between May and September.

Non-Seasonal Consumption
To the extent that consumption of commodity is seasonal, temporary imbalances between supply and demand can occur. Example: propane gas during winter Turkeys during thanksgiving

High Storability
A market moves closer to full carry if its underline commodity can be stored easily. The Cost-of-Carry Model is not likely to apply to commodities that have poor storage characteristics. Example: eggs

Hedging with futures: Hedging and Basis

At any date t, the basis is the spot price minus the forward price for a contract maturing at date T,
Bt,T = St Ft,T

Initial basis at date 0 (B0,T)will always be known since both the current spot and forward contract prices can be observed. Consider an investor who hedges her long position in a commodity by taking a short position in a forward contract(delivering the commodity at maturity).

Example on Basis Risk

Suppose, an investor wishes in March to hedge a long position of 100, 000 pounds of cotton she is planning to sell in June. However, each futures contract is requiring only 50, 000 pounds of cotton. Therefore, she decides to short two of the July contracts (intending to liquidate her position before the maturity) Suppose, in the beginning, the spot cotton price was $0.4834 per pound and the July futures contract was $0.5305 per pound.

Calculate initial basis.

Suppose, cotton prices have declined so that cash price in June are $0.4660 and futures are trading at $0.4753.

Calculate basis for June

Basis has increased in value or strengthened, which is to the short hedgers advantage.

Now, she sells cotton in cash market for $0.4660

At the same time she also sells the futures for its contract value i.e. $0.5305 whereas the market future price is $0.4753; it means that she has made a profit of (0.5305 0..4753) = $0.0552

Therefore, at date 0, B0,T= S0 F0,T At date t, Bt,T = St Ft,T

Therefore, the profit from the short hedge liquidated at date t is

Bt,T B0,T = (St Ft,T) (S0 F0,T)

Similarly, one can calculate the profit for the long hedger as
B0,T Bt,T = (S0 F0,T) (St Ft,T)

There are 3 ways to close a futures position

Delivery or cash settlement
Most commodity futures contracts are written for completion of the futures contract through the physical delivery of a particular good. Most financial futures contracts allow completion through cash settlement. In cash settlement, traders make payments at the expiration of the contract to settle any gains or losses, instead of making physical delivery.

Offset or reversing trade

If you previously sold a futures contract, you can close out your position by purchasing an identical futures contract. The exchange will cancel out your two positions.

Exchange-for-physicals (EFP) or ex-pit transaction

Two traders agree to a simultaneous exchange of a cash commodity and futures contracts based on that cash commodity.

An Exchange-for-Physicals Transaction
Before the EFP Trader A Long 1 wheat futures Wants to acquire actual wheat Trader A Agrees with Trader B to purchase wheat and cancel futures Receives wheat; pays Trader B Reports EFP to exchange; exchange adjusts books to show that Trader A is out of the market Trader B Short 1 wheat futures Owns wheat and wishes to sell EFP Transaction Trader B Agrees with Trader A to sell wheat and cancel futures Delivers wheat; receives payment from Trader A Reports EFP to exchange; exchange adjusts books to show that Trader B is out of the market

Forwards and Futures: Basic Evaluation Concepts

Since the futures or forwards dont require front-end from either the long or short transaction; therefore, the contracts initial market value is usually zero.

Valuing forwards and futures

Spread two futures contracts on A spread is the difference in price between

the same commodity for two different maturity dates:

Spread F 0, t k F 0, t
F0,t = The current futures price for delivery of the product at time t.
This might be the price of a futures contract on wheat for delivery in 3 months.

F0,t+k = The current futures price for delivery of the product at time t +k.
This might be the price of a futures contract for wheat for delivery in 6 months.

Spread relationships are important to speculators.

The relationship between spot and forward prices Suppose you buy the corn now for the current cash price of S0 per bushel and store
it until you have to deliver it at date T, the forward price you would be willing to commit would have to be high enough to cover
The present cost of the corn and The cost of storing the corn until contract maturity

These storage costs involve

Commission paid to the warehouse for storing Cost of financing the initial purchase LESS cash flows received by owing the asset.

F0,T = S0 + SC0,T

= S0 + (PC0, T + i 0, T D0, T)

Cost-of-carry model of futures prices

The common way to value a futures contract is by using the Costof-Carry Model. The Cost-of-Carry Model says that the futures price should depend upon two things:
The current spot price. The cost of carrying or storing the underlying good from now until the futures contract matures.

Assumptions:
There are no transaction costs or margin requirements. There are no restrictions on short selling. Investors can borrow and lend at the same rate of interest.

Two arbitrage strategies with Cost-ofcarry model

Cash-and-carry arbitrage
Reverse cash-and-carry arbitrage

A cash-and-carry arbitrage
A cash-and-carry arbitrage occurs when a trader borrows money, buys the goods today for cash and carries the goods to the expiration of the futures contract. Then, delivers the commodity against a futures contract and pays off the loan. Any profit from this strategy would be an arbitrage profit.
0 1

1. Borrow money 2. Sell futures contract 3. Buy commodity

4. Deliver the commodity against the futures contract 5. Recover money & payoff loan

A reverse cash-and-carry arbitrage

A reverse cash-and-carry arbitrage occurs when a trader sells short a physical asset. The trader purchases a futures contract, which will be used to honor the short sale commitment. Then the trader lends the proceeds at an established rate of interest. In the future, the trader accepts delivery against the futures contract and uses the commodity received to cover the short position. Any profit from this strategy would be an arbitrage profit.
0 1

1. Sell short the commodity 2. Lend money received from short sale 3. Buy futures contract

4. Accept delivery from futures contract 5. Use commodity received to cover the short sale

Transactions for Arbitrage Strategies

Market Debt Physical Futures Cash-and-Carry Borrow funds Buy asset and store; deliver against futures Sell futures Reverse Cash-and-Carry Lend short sale proceeds Sell asset short; secure proceeds from short sale Buy futures; accept delivery; return physical asset to honor short sale commitment

The Cost-of-Carry Model can be expressed as:

F 0 , t S 0(1 C 0 , t )
S0 F0,t = = the current spot price the current futures price for delivery of the product at time t.

C0,t = the percentage cost required to store (or carry) the commodity from today until time t.

The cost of carrying or storing includes:

Storage costs Insurance costs Transportation costs Financing costs

Cost of carry Rule 1

The futures price must be greater than or equal to the spot price of the commodity plus the carrying charges necessary to carry the spot commodity forward to delivery.

F 0 , t S 0(1 C 0 , t )
0 1

1. Borrow $400 2. Buy 1 oz gold 3. Sell futures contract

4. Deliver gold against futures contract 5. Repay loan

Cash-and-Carry Gold Arbitrage Transactions

Prices for the Analysis: Spot price of gold Future price of gold (for delivery in one year) Interest rate Transaction t=0 Borrow $400 for one year at 10%. Buy 1 ounce of gold in the spot market for $400. Sell a futures contract for $450 for delivery of one ounce in one year. Remove the gold from storage. Deliver the ounce of gold against the futures contract. Repay loan, including interest. $400 $450 10% Cash Flow +$400 - 400 0 Total Cash Flow t=1 $0 $0 +450 -440 Total Cash Flow +$10

Another example
Suppose the stock is trading today at 120 when the risk-free rate of interest is 5% What should be the forward price of the stock at the end of one year? 120 x 1.05 = 126 Now, if the forward/futures price is 128. Is there any arbitrage possibility? If yes, calculate the arbitrage profit. Assume
The stock is not paying any dividend during the period. Storage cost is NIL

Cost of carry Rule 2

The futures price must be equal to or less than the spot price of the commodity plus the carrying charges necessary to carry the spot commodity forward to delivery.
0

F 0 , t S 0(1 C 0 , t ) 1
4. Collect proceeds from loan 5. Accept delivery on futures contract 6. Use gold from futures contract to repay the short sale

1. Sell short 1 oz. gold 2. Lend $420 at 10% interest 3. Buy a futures contract

Reverse Cash-and-Carry Gold Arbitrage Transactions

Prices for the Analysis Spot price of gold Future price of gold (for delivery in one year) Interest rate Transaction t=0 Sell 1 ounce of gold short. Lend the $420 for one year at 10%. Buy 1 ounce of gold futures for delivery in 1 year. Collect proceeds from the loan ($420 x 1.1). Accept delivery on the futures contract. Use gold from futures delivery to repay short sale. $420 $450 10% Cash Flow +$420 - 420 0 Total Cash Flow t=1 $0

+$462 -450 0 Total Cash Flow +$12

Another example
Suppose the stock is trading today at 120 when the risk-free rate of interest is 5% What should be the forward price of the stock at the end of one year? 120 x 1.05 = 126 Now, if the forward/futures price is 123. Is there any arbitrage possibility? If yes, calculate the arbitrage profit. Assume
The stock is not paying any dividend during the period. Storage cost is NIL

Since the futures price must be either greater than or equal to the spot price plus the cost of carrying the commodity forward by rule #1.
And the futures price must be less than or equal to the spot price plus the cost of carrying the commodity forward by rule #2. The only way that these two rules can reconciled so there is no arbitrage opportunity is by the cost of carry rule #3. Rule #3: the futures price must be equal to the spot price plus the cost of carrying the commodity forward to the delivery date of the futures contract.

Cost of carry Rule 3

F 0 , t S 0(1 C 0 , t )

If prices were not to conform to cost of carry rule #3, a cash-and carry arbitrage profit could be earned.

Recall that we have assumed away transaction costs, margin requirements, and restrictions against short selling.

Spreads and the cost-of-carry

As we have just seen, there must be a relationship between the futures price and the spot price on the same commodity. Similarly, there must be a relationship between the futures prices on the same commodity with differing times to maturity. The following rules address these relationships:

Cost-of-Carry Rule 4
Cost-of-Carry Rule 5 Cost-of-Carry Rule 6

Cost-of-carry rule no 4
The distant futures price must be greater than or equal to the nearby futures price plus the cost of carrying the commodity from the nearby delivery date to the distant delivery date.

F 0, d F 0, n(1 Cn , d )

F0,d = the futures price at t=0 for the distant delivery contract maturing at t=d. Fo,n= the futures price at t=0 for the nearby delivery contract maturing at t=n. Cn,d= the percentage cost of carrying the good from t=n to t=d. If prices were not to conform to cost of carry rule # 4, a cash-and-carry arbitrage profit could be earned.

Rule No 4
0 1 2

1. Buy futures contract w/exp in 1 yrs. 2. Sell futures contract w/exp in 2 years 3. Contract to borrow $400 from yr 1-2

4. Borrow $400 5. Take delivery on 1 yr to exp futures contract. 6. Place the gold in storage for one yr.

7. Remove gold from storage 8. Deliver gold against 2 yr. futures contract 9. Pay back loan

Gold Forward Cash-and-Carry Arbitrage

Prices for the Analysis Futures price for gold expiring in 1 year Futures price for gold expiring in 2 years Interest rate (to cover from year 1 to year 2) Transaction t=0 Buy the futures expiring in 1 year. Sell the futures expiring in 2 years. Contract to borrow $400 at 10% for year 1 to year 2. Total Cash Flow t=1 Borrow $400 for 1 year at 10% as contracted at t = 0. Take delivery on the futures contract. Begin to store gold for one year. $400 $450 10% Cash Flow +$0 0 0 $0

+$400 - 400 0 Total Cash Flow $0 +$450 - 440 Total Cash Flow + $10

t=2

Deliver gold to honor futures contract. Repay loan ($400 x 1.1)

Rule No 5
The nearby futures price plus the cost of carrying the commodity from the nearby delivery date to the distant delivery date cannot exceed the distant futures price. Or alternatively, the distant futures price must be less than or equal to the nearby futures price plus the cost of carrying the commodity from the nearby futures date to the distant futures date.

F0,d F0,n 1 Cn,d

If prices were not to conform to cost of carry rule # 5, a reverse cash-and-carry arbitrage profit could be earned.

Rule N0 5
0 1 2

1. Sell futures contract w/exp in 1 yrs. 2. Buy futures contract w/exp in 2 years 3. Contract to lend $400 from yr 1-2

4. Borrow 1 oz. gold 5. Deliver gold on 1 yr to exp futures contract. 6. Invest proceeds from delivery for one yr.

7. Accept delivery on exp 2 yr futures contract 8. Repay 1 oz. borrowed gold. 9. Collect $400 loan

Gold Forward Reverse Cash-and-Carry Arbitrage

Prices for the Analysis: Futures price for gold expiring in 1 year Futures price for gold expiring in 2 years Interest rate (to cover from year 1 to year 2) Transaction t=0 Sell the futures expiring in one year. Buy the futures expiring in two years. Contract to lend $440 at 10% from year 1 to year 2. Total Cash Flow t=1 Borrow 1 ounce of gold for one year. Deliver gold against the expiring futures. Invest proceeds from delivery for one year. Total Cash Flow t=2 Accept delivery on expiring futures. Repay 1 ounce of borrowed gold. Collect on loan of $440 made at t = 1. $440 $450 10% Cash Flow +$0 0 0 $0 $0 + 440 - 440 $0

- $450 0 + 484 Total Cash Flow + $34

What does this all mean?

Since the distant futures price must be either greater than or equal to the nearby futures price plus the cost of carrying the commodity from the nearby delivery date to the distant delivery date by rule #4.
And the nearby futures price plus the cost of carrying the commodity from the nearby delivery date to the distant delivery date can not exceed the distant futures price by rule #5. The only way that rules 4 and 5 can be reconciled so there is no arbitrage opportunity is by cost of carry rule #6.

Rule No 6
The distant futures price must equal the nearby futures price plus the cost of carrying the commodity from the nearby to the distant delivery date.

F 0, d F 0, n(1 Cn , d )

If prices were not to conform to cost of carry rule #6, a cash-and-carry arbitrage profit or reverse cash-and-carry arbitrage profit could be earned. Recall that we have assumed away transaction costs, margin requirements, and restrictions against short selling.

Financial Forwards and Futures

INTEREST RATE EQUITY INDEX FOREIGN EXCHANGE

Interest Rate Forwards and Futures

Long-term interest rate futures

Short-term interest rate futures

Long-term Interest Rate Futures

Common Futures Terminology

Bull Market

A bull market is a market in which prices are rising. When someone is referred to as being bullish, that person has an optimistic outlook that prices will be rising.

Bear Market

A bear market is one in which prices are falling. Therefore, a bearish view is pessimistic, and that person would believe that prices are heading downward.

Going Long
If you were to buy a futures contract to initiate a position, you would be long. A person who has purchased 10 pork belly futures contracts is long 10 pork belly contracts. Someone who is long in the market expects prices to rise. They expect to make money by later selling the contracts at a higher price than they originally paid for them.

Going Short
A more difficult concept involves the sale of futures contracts before buying them. Someone who sells a futures contract to initiate a position is said to be short for example, short 10 pork belly contracts would mean that a person initiated a position by selling those 10 contracts. But dont confuse this concept with someone who originally went long by purchasing futures contracts and is now selling them to offset his or her position in the market.

A short seller has entered into an obligation to deliver a commodity at a future date, at a price agreed upon today, but with the ability to offset that obligation by buying back the futures contract.

Contract Maturities
Futures contracts have limited lives, known as contract maturities. Contract maturity is expressed in terms of months, such as December. The contract maturity designates the time at which deliveries are to be made or taken, unless the trader has offset the contract by an equal, opposite transaction prior to maturity.

Futures contracts are typically traded up to one year into the future, while some commodities may trade more than two years into the future.

Many contracts expire quarterly specifically towards the end of March, June, September and December.

Delivery
Only about 3% of all futures contracts actually result in physical delivery or cash settlement of the commodity. The other 97% are simply offset.

That means that the majority of participants close out their positions prior to the contracts delivery date (sellers buy back the futures they sold, and buyers sell back the futures they bought).

For some futures contracts, such as stock index futures, there is no physical delivery. Rather, positions are closed out through cash settlement.

On the day following the final trading day, open contract positions are settled in cash with no deliveries of the securities. The full value of the contract is not transferred to your performance bond account. Instead there is a final marking-to-themarket of the contract position to the actual index based upon the opening values of the stocks, with the final gain or loss applied to the performance bond accounts.

With this cash delivery feature, liquidity is ensured to the last day of trading of the contract.

Hedge
If you hedge, you buy or sell a futures contract as a temporary substitute for a cash market transaction to be made at a later date.

Hedging usually involves holding opposite positions in the cash market and futures market at the same time.
Hedging is a business management tool used to manage price risk.

Long Hedge
If you put on a long hedge you purchase a futures contract in anticipation of an actual cash market purchase.

Processors or exporters typically use long hedges as protection against an increase in the cash price.
Short Hedge To put on a short hedge you would sell a futures contract in anticipation of a later cash market sale. Traders use short hedges to eliminate or lessen the possible decline in value of ownership of an approximately equal amount of a cash financial instrument or physical commodity.

Speculator
You would be considered a speculator if you bought and sold futures contracts for the sole purpose of making a profit. Speculators attempt to anticipate price changes. They do not use the futures markets in connection with the production, processing, marketing or handling of a product, and have no interest in making or taking delivery.