Financial
Derivative
Forward and Future
Contracts
Forward Contract
• In a forward contract, the
purchaser and its counterparty are
obligated to trade a security or
other asset at a specified date in the
future .
• Options ate traded on OTC
How is the exchange rate for a
Forward Contract determined?
• A forward rate is calculated by looking at
the interest rate difference between the two
currencies involved.
• In the forward market, the currency of a
country with lower interest rates than our
currency will trade at a "premium". The
currency of a country with higher rates than
ours will trade at a "discount".
Example
if a client is buying a 30 day US dollar
forward contract, the difference between the
spot rate and the forward rate is calculated
as follows:
Assume
The interest rate earned on US$ is less
than the interest rate earned on CAD$.
•if Calforex sells $100,000USD transaction
the spot market was 1.52 and the interest rate
differential was 1%, the 30 day forward
contract rate would be calculated as follows:
$100,000USD x 1.5200 = $152,000 CAD
$152,000CAD x 1% divided by 12 months =
$126.67
$152,000CAD + $126.67 = $152,126.67CAD
$152,126.67CAD/$100,000USD = 1.5213
Therefore, in this example the forward rate
would be 12 points higher than the spot rate
on a thirty-day contract.
How The forward contract works
• An example a farmer is about to plant his
summer crop of wheat, and estimates it will
cost $3.00 per bushel to grow the wheat.
The farmer expects that the crop will yield
one hundred thousand bushels at harvest
time. The farmer enters into a forward
contract with a buyer of the wheat crop who
has a use for the crop, to sell the anticipated
one hundred thousand bushels of wheat at
predetermined price and date.
The Advantage/Disadvantage of A
forward Contract
Disadvantage
Advantage
• Both parties
• You must make or take delivery of
have limited
their risk
•
•
the commodity and settle on the
deliver date and honor the contract
as agreed upon
The buyer and seller are
dependent upon each other.
In a forward contract, any profits or
losses are not realized until the
contract "comes due" on the
predetermined date.
Future Contract
• A future is a standardized derivative contract
between two parties: a buyer and a seller.
• Being a standardized contract means that the
buyer and seller do not contract directly with
each other. Instead, they contract with the
intermediary known as the
clearinghouse. The clearinghouse protects
their potential liability by requiring that
margin be deposited and all positions are
marked-to-market on at least a daily basis.
Marking-to-market
• The installment method used with futures is
called “marking-to-the-market”.
Clearing House
• Act as a third party-go-between on all buys
and sells
Margin
• With a hedging strategy, must establish and
maintain a margin account (performance
bond) with broker as insurance against
defaulting on any loss. .
• Initial margin: Initial deposit of funds
required to be deposited.
• Amount required in this account varies from
broker to broker
• Minimum margin requirements for a
particular futures contract at a particular
time are set by the exchange on which the
contract is traded. They are typically five to
10 percent of the value of the futures
contract
• Margin calls may bring the value of your
margin account to original initial margin
level. Small loss allowed before margin
calls.
• Maintenance margin is the loss level which
initiates a margin call..
• Note that once a trader recieves a margin
call, he must meet that call, even if the price
has subsequently moved in his favor.
• If no money is deposited on the day of the
margin call or early the next morning, the
commodity broker will automatically make
an offset trade to terminate the client’s
futures position. Brokers will offset, in this
case, to protect the brokerage house.
• Example:Marking to the market
Buy 2 March S&P 500 Futures
@$1000 = 2*250*$1000=250000
Initial margin = 25000
Maintainance margin = 20000
D
Futures
Price $
Action
0 1000.00 Buy contract
1 1005.00 Seller pays
buyer
2 1015.00 Seller pays
buyer
3 995.00 Buyer pays
seller
4 985.00 Buyer pays
seller
5 990.00 Seller pays
buyer
Cash
Flow $
D/W
$
Account
Equity $
0
25000 25000
2500
27000
5000
1000 31500
-10000
21500
-5000
8500 25000
2500
27500
Contract obligation:Delivery or
Offset
• A holder of a future contracts has 2 choices
of how to deal with the legal obligations
before the last trading day of the delivery
month
1. Delivering or taking delivery
2. Offset
Forward vs. Futures Contracts
•
•
•
•
•
•
Rules
Organized market place / OTC
Standardized trading
Guaranteed settlement
Margin and Daily settlement
Liquidity