Forward Contract

• Example: A corn flakes manufacturer (company) and a corn

producer (farmer) agreeing to trade in corn produced at a future date
at a price agreed upon today.

• Farmer agreeing to sell 20 tons of wheat at Rs. 20 per kg to a rolling

mill to be delivered in November next.

• An exporter expecting to receive $10,000 after six months may

agree to sell the same to a bank at an exchange rate of Rs. 55
decided today but foreign exchange delivered only after six months.

• The forward price of the asset is Rs. 20 per kg for wheat, and Rs 55
for dollars.
Features of a Forward Contract
– Two parties (buyer and seller)
– OTC
– Price is determined today
• (Price is negotiated in advance)
– Mutual Obligation to Perform
• ( on maturity, seller makes the delivery and buyer pays the
price)
– Counter Party Risk
– Mutual consent for cancellation
– No front end Payment
• No exchange of money at the time of entering forward
contract though either party can insist on initial deposit
against price or delivery to mitigate risk
 Forward Contract
• Forward Contracts
– Definition: a contract between two parties for
one party to buy something from the other at
a later date at a price agreed upon today
– Exclusively over-the-counter
• Futures Contracts
– Forward Contract traded in an exchange

– Definition: a contract between two parties for one

party to buy something from the other at a later date
at a price agreed upon today; subject to a daily
settlement of gains and losses and guaranteed
against the risk that either party might default
– Exclusively traded on a futures exchange
 Organized Futures Trading
Contract Terms and Conditions
– contract size
– quotation unit
– minimum price fluctuation
– contract grade
– trading hours
• Delivery Terms
– delivery date and time
– delivery or cash settlement
 Difference between Futures and
Forwards
Futures Market Forward Market

Location Futures Exchange No fixed Location

Size of Contract Fixed (standard) Depends on Contract

Maturity Fixed (standard) Depends on Contract

Counterparty Clearing House Known Bank or Client

Valuation Marked-to-Market Everyday No unique Method

Variation Margin Daily None

Regulations Regulated by Exchange Self Regulated

Credit Risk Almost Non Existent Depends on Counterparty

Settlement Through Clearing House Depends on Contract

Liquidation Mostly by Offsetting the positions Mostly settled by actual delivery

 Open Interest And Volume
• Ex-1
Period 1
Trader A Sells one Futures Contract and Trader
B buys one Futures contract
Period 2
Trader A buys one Futures contract and trader C
sells one
Period 3
Trader C Buys one Futures contract and Trader
B sells one Futures Contract.
 Open
Time A B C Volume interest

1 Sells 1 Buys 1 1 1

2 Buys 1 Sells 1 1 1

3 Sells 1 Buys 1 1 0
 Open Interest And Volume
• Ex-2
 Open Interest And Volume

• Open Interest is a measure of how many Futures

contract exist at any particular time.

• It shows the number of long positions not squared off or

number of short positions not squared off at any
particular point of time.

• Futures contracts are created and destroyed (expired)

depending on how trades are matched up

• Volume Simply measures how many trades occurred.

 Newspaper
• Futures
• Ex: Reliance-September
• Delivery Month
– All contracts of a month expire on the last Thursday of
the month.

• Open high low close

• Value
• No of contracts
• Open Interest and Volume
Futures and Forward Contracts
(cont’d)
The futures market deals with transactions
that will be made in the future.

A person who buys in October a December

Reliance futures contract promises to pay a
certain price for Reliance in December.

If you buy the Reliance today, you purchase

them in the cash, or spot market.
 Problem
• On October 1st
– Reliance Spot Price is Rs. 1000
– Reliance (December Futures/Forward price) = 1050

• On November 10th
– reliance spot price is 1200 and futures price is 1275

• In December at expiration date

– Reliance trades at 1100
 Forward Market

Date Spot Forward( December contract)

1-Oct 1000 1050 ( Mutually Agreed Price)

November 10th 1200 SO what ?

December (Maturity) 1100 Honor the contract

 Pay Off in Forward Market at
Maturity
Payoff of Long futures (if you buy Reliance Forward contract)
=Sell price – Buy price
= Spot price at expiration – forward price
=1100-1050 =50

Pay off of short futures ( if you sell Reliance Forward contract)

=Sell price – Buy price
= Forward Price – Spot price at expiration
=1050-1100= -50

• Because One contract is for 600 shares. Your profit or loss gets
multiplied by 600 times.
 Futures Market

Futures( December
Date Spot contract)

1-Oct 1000 1050

November 10th 1200 1275

December
(Maturity) 1100 1100
 Payoff on Futures Contract at
expiration
Payoff of Long futures (if you buy Reliance Forward
contract)
=Sell price – Buy price
= Spot price at expiration – forward price
=1100-1050 =50

Pay off of short futures ( if you sell Reliance Forward

contract)
=Sell price – Buy price
= Forward Price – spot price at expiration
=1050-1100= -50
 Payoff of Futures Contract on
November 10th
• Payoff of Long futures = Sell price –
Buy price
• = 1275-1050 =225

• Pay off of short futures = Sell price –

Buy price
• = 1050 – 1275= -225
 Futures Contracts (cont’d)
• A futures contract involves a process
known as marking to market
– Money actually moves between accounts
each day as prices move up and down

• A forward contract is functionally

similar to a futures contract, however:
– There is no marking to market
– Forward contracts are not marketable
 Problem
Settlement
Day Price
1 4700
2 4500
3 4650
4 4750
5 4700
The initial margin is set at Rs. 10,000 per contract, while the maintenance
margin is Set at Rs. 8000 per contract. The multiple of each contract is 50.

Calculate the mark-to-market cash flows and the daily closing balances in
Accounts of.
A) An investor who has gone long at 4600 on day ‘0’.
B) An investor who has gone short at 4600 on day ‘0’.
C) Calculate the net profit/loss on each of the contracts.
Investor Who has gone long at 4600 (initial margin =10,000 and Maintenance margin = 8,000)

Opening Mark-to- Is the balance Margin Closing

Day Settlement Price Balance Market < 8000 Call Balance
Bought 50 @
0 4600 10000 - - - 10000

1 4700 10000 5000 NO 15000

2 4500 15000 -10000 YES 5000 10000

3 4650 10000 7500 NO 17500

4 4750 17500 5000 NO 22500

5 4700 22500 -2500 NO 20000

Total Profit/Loss 5000

Investor Who has gone Short at 4600 (Initial margin =10,000 and Maintenance margin = 8,000)

Mark-to- Is the Closing

Settlement Opening Mar balance Margin Bala
Day Price Balance ket < 8000 Call nce
Sold 50 @
0 4600 10000 - - - 10000

1 4700 10000 -5000 Yes 5000 10000

2 4500 10000 10000 NO 20000

3 4650 20000 -7500 NO 12500

4 4750 12500 -5000 Yes 2500 10000

5 4700 10000 2500 NO 12500

Total
Profit/Loss -5000
 BASIS
• The difference between spot price and
futures price is called Basis.

• Basis= Spot Price - Futures Price

 Reliance Spot and Futures Prices

Futures and Spot Price

620

600

580
Futures_Price
560
STOCKPRICE
540

520

500
T 28 27 24 23 22 21 20 17 16 15 14 13 10 9 8 7 6 2 1
Time to Maturity
 Behavior of Basis
• When the futures price is at expiration, the
futures price of reliance and spot price of
reliance must be same.

• That is the basis must be zero.

• This behavior of basis over time is called

convergence
 When basis is constant you get perfect
hedge
Hedge 1; Long in spot and sell in futures
Spot Price Futures Price Basis
before maturity 10 15 -5
before Maturity 20 25 -5
Profit/Loss 10 -10

Hedge 2; Short in spot and buy in futures

Spot Price Futures Price Basis
Some time Bef. Mat 10 15 -5
Before Maturity 20 25 -5
Profit/Loss -10 10
 Basis Risk
Basis risk arises because basis does not remain constant

• We know that Basis at maturity is always equal to ZERO.

• At the time of purchase of futures contract the basis is either

negative or positive

• You have either positive or negative basis at start and if you hold the
contract until maturity basis will become zero

• Implies Basis rarely will be constant during the holding period of the
contract.
 Basis Risk

Nature Of
hedge Basis At the start

Positive Negative
BUY (Futures)
and Hold until
maturity Favorable Adverse
SELL (Futures)
Hold Until
Maturity Adverse Favorable
 When Basis is negative at start
Hedge 1; Long in spot and sell in futures
Futures
Spot Price Price Basis Total P/L
before mat. 10 15 -5
At maturity 20 20 0
Profit/Loss 10 -5 5

Hedge 2; Short in spot and buy in futures

Futures
Spot Price Price Basis
Before Mat. 10 15 -5
At Maturity 20 20 0
Profit/Loss -10 5 -5
 When Basis is Positive at start
Hedge 1; Long in spot and sell in futures
Futures
Spot Price Price Basis Total P/L
20 15 5
At maturity 20 20 0
Profit/Loss 0 -5 -5

Hedge 2; Short in spot and buy in futures

Futures
Spot Price Price Basis
20 15 5
At maturity 20 20 0
Profit/Loss 0 5 5
 Basis Risk

Nature Of
hedge Basis At the start

Positive Negative

BUY (Futures) Favorable Adverse

SELL (Futures) Adverse Favorable

 How are Futures Prices
Determined
• How to determine Futures Prices.
• How are Futures prices related to Spot
Price.
 Models of Future Prices
• Model No 1
– Cost of Carry Model

• According to this model futures price

depend on the cash price of a commodity
and the cost of storing the underlying good
from the present to the delivery date of the
futures contract.
 Cost of Carry Model
• The cost of carry model in perfect markets.

• The cost of carry or carrying charge is the total cost to

carry a good forward in time.

• For example, wheat on hand in June can be carried

forward to, or stored until, December
• Carrying charges fall into four basic categories.
– Storage Costs
– Insurance Costs
– Transportation Costs
– Financing Costs
 Cost of Carry Model
• The carrying charge reflects only the charges involved in
carrying a commodity from one time or one place to
another.

• The carrying charges do not include the value of

commodity itself.

• So, if gold costs $400 per ounce and the financing rate is
1 percent per month,

• the financing charge for carrying the gold forward is $ 4

per month (1%X$400)
What Should be Futures Price?
• Let us assume that
– futures price > Spot + Cost to Carry
 Cash and Carry gold – Arbitrage Transactions

• Prices for the analysis:

– Spot price of gold $400
– Future price of Gold ?
– Interest Rate 10%

• Let Future price = $450

• T=0
– Borrow $ 400 for one year at 10% +$400
– Buy one ounce of gold in the spot market -$400
– Sell a futures contract for $450 for delivery
of one ounce in one year $0
• T=1
• Remove the gold from storage $0
• Deliver the ounce of gold against the futures contract $450
• Repay loan, including interest -$440

• Total Cash Flow +$10

 Cash and Carry gold – Arbitrage Transactions

Cash and Carry Gold: Long in spot and Short in futures

Spot Price Futures Price Basis

Time 0 400 450 -50

Time 1 10000 10000 0

Profit/Loss 9600 -9550 50

Cost of Borrowing = 40

Net Profit 10
 Cash and Carry Arbitrage
• Rule 1: If Future Price > Spot + Cost to carry
then traders could carry out cash and carry
arbitrage

• Hence :
– Futures price must be less than or equal to the spot
price of the commodity plus the carrying charges
necessary to carry the spot commodity forward to
delivery. ( To avoid arbitrage)
What should be Futures Price?
• Let us Assume that
– Futures Price < Spot + Cost to Carry
 Reverse Cash and Carry gold –
Arbitrage Transactions
• Prices for the analysis:
– Spot price of gold $400
– Future price of Gold ?
– Interest Rate 10% p.a

• Let Future price = $430

• T=0
– Sell one ounce of gold +$400
– Lend $ 400 for one year at 10% -$400
– Buy one ounce of gold futures contract for $450 for delivery
of one ounce in one year $0
• T=1

• Collect proceeds from the loan ($400 X1.1) $440

• Accept delivery on the futures contract -$430
• Use gold from futures delivery to repay short sale $0

• Total Cash Flow +$10

 Reverse Cash and Carry Arbitrage
• Rule 2 : If future price < Spot Price + Cost of
Carry then traders could carry out reverse cash
and carry arbitrage

• Hence :
– Futures price must be greater than or equal to the
spot price of the commodity plus the cost of carrying
the good to the future delivery date. (To avoid
arbitrage)
No Arbitrage future price in Perfect
Markets
• Combining Rule one and Two.
• We have
Only when

• Futures price = Spot Price + Cost of Carrying

»Then Arbitrage is Not possible

 Cost of Carry Model
Assuming Perfect markets and no arbitrage
conditions

FP = spot price + cost to carry

 Cost of Carry Model
• If futures price follow cost of carry model then basis is negative.

• FP = Spot + cost of carry.

• Since Futures price is always more than spot price: Basis is always
negative.

• Given FP = Spot price (SP) + Cost to carry (X)

• Basis = Spot price – Futures price

= Spot price – (spot price + x)
= -x
 Contango Market
• When futures price is higher than cash
price then the market is said to be in
“Contango” or “Normal”.
Or
when Basis is negative then Market is said
to be in “Contango”.
Or
When the market follows Full cost of carry
model then it is called “Contango” Market.
Can the Basis be Positive?
 Convenience Yield
• When an asset has convenience yield then full cost of carry model does not
hold.

• Convenience Yield is a return on holding an Asset

• Anybody who has use of an asset for consumption can derive “Convenience
Yield”.
• Ex: Food processor might Derive a convenience yield by holding on to
commodity.

• When Futures price is below cash price or spot price then you need to do
reverse cash and carry arbitrage to exploit it.

• But because (say soya beans) has convenience yield there will be no one
willing to lend. Hence short selling of beans will not be possible.
 Backwardation
• When basis is positive then the market is said to be in
backwardation or “Inverted”.

• Expectation Model
– The price of the Futures contract is the expected Future Spot
Price.
• Normal Backwardation Hypothesis
– If hedgers are net short and speculator are net long- then future
price must be below the future spot price (speculators demand
premium for risk)
– Contango – If hedgers are net long and speculators are net short
then future price must be above the future spot price.
 Role of Speculators and
Expectation Model
• If the Futures price were $15 , exceeding
the expected Futures spot price of $10.
Then speculators would sell futures at $
15 and on maturity they would buy back
the futures at $10 and make a profit.

• In effect speculators would make sure that

Futures price is equal to expected Future
Spot Price.
 Who would trade in Futures?
Futures trading will be of interest to those who wish to:

1) Price Risk Transfer - Hedging

2) Invest- Speculating

3) Arbitrage

4) Leverage
Currency Futures- Hedging
 Example – Hedging (Futures)

– Company A must Pay £1 Million in September for imports from Britain.

– Company B will receive £3 Million in September from exports to Britain

• Current Exchange Rate Rs/ £ = 70.2039

• September Futures Price Rs/ £ = 69.9147
• in September at expiration spot price is 71
• Size of Futures Contract £ 62500

• Company A’s Hedging Strategy

– (pay means Short in SPOT)
– Buy (Long) Position in 16 Futures Contracts. This locks in the exchange rate of
69.9147 for the £1 Million it will pay

• Company B’s Hedging Strategy

– Receive means (Long in SPOT)
– Sell (Short) Position in 48 Futures Contracts. This locks in an exchange rate of
69.9147 for the £3 Million it will receive.
 Company A

Short position in Long Position in Futures

Cash Market market

Time Spot Futures Basis Profit/Loss

Right now 70.2039 69.9147 0.289

At maturity 71 71 0

Pay off -0.7961 1.0853 0.2892

 Company B

Long position in Short Position in Futures

Cash Market market
Time Spot Futures Basis Profit/Loss
Right now 70.2039 69.9147 0.2892
At maturity 71 71 0
Pay off 0.7961 -1.0853 -0.2892
• Total profit in spot = .7961*3,000,000
=2,388,300

• Total Loss in futures = -1.0853* 48*62500

=-3,255,900

• Net Loss =867,600

 Hedge Ratio
Can I hedge the loss due to basis Risk ?
 Company B

Long position in Short Position in Futures

Cash Market market
Time Spot Futures Basis Profit/Loss
Right now 70.2039 69.9147 0.2892
At maturity 71 71 0
Pay off 0.7961 -1.0853 -0.2892
• Instead of 48 futures contracts If Company
B had sold 35.20943 contracts then it
would have resulted in perfect hedge.

Loss in futures =35.20943*62500* (-1.0853)

=-2,388,300
Which is exactly equal to the profit in spot.
• Hedge Ratio = Futures position/Underlying
Asset Position

• Hedge Ratio =35.20944/48

=0.73353 (.7961/1.0853)
 How to estimate Hedge ratio
Change (St)= alpha + beta *change (Ft) + error term

Change (St) = change in cash price on day t

Change (Ft) = change in futures price on day t

Beta gives the hedge ratio.

Beta = Covariance (S,F) /variance (F) or

Beta = correlation coefficient (S,F)* standard deviation (S)/
Std. dev of (F)
 Speculators
• Exploit the differences in own forecast and
market expectations.
Speculation Using Currency futures
• Problem
– Rs/$ spot = 45.1
– March futures = 45.30
– June Futures = 45.34
– September futures = 45.60

– Mr. A, a forex dealer, holds the view that the market is

wrong and the $ will actually depreciate.
– What strategy should they adopt
• Depreciating Dollar means appreciating
rupee.
• Appreciating Rupee means that for each
Dollar you would get less rupees
• Rate of 45 now could become 44 and so
on in the future.
• Sell futures now and buy back futures later as
they expect the dollar to depreciate.
• Calculate profit and loss if
– if on September 10th following rates prevail.
– Scenario 1
• Spot Rs/$ = 45.5
• September Future = 45.70
– Scenario 2
• Spot Rs /$ = 45.3
• September Future = 45.4
• Assume contract size to be 1 million dollars.
• Scenario 1
– Pay off = Sell price – buy price
=45.6-45.7 = - .1 * 1 million = Loss of 1 lakh

Scenario 2
Pay off = sell price – buy price
=45.6-45.4 = .2 * 1 million = profit of 2 lakhs