EFB210 Lecture Notes - Lecture 10: Futures Contract, Forward Contract, Futures Exchange
Week 10 Finance 1 Lecture Notes
Introduction to Derivatives and Risk Management
Derivatives Defined
• A security that derives its value from an underlying security, commodity or event.
• There are several types of derivative contracts:
o Forward Contract
▪ An agreement to trade a commodity, financial security, etc... at a
future date.
▪ e.g. currencies
• Futures Contract
o Similar to a forward, but highly standardised and exchange traded.
▪ e.g. commodities (Wheat) or financial securities (Bank Bills)
• Swap Contract
o A package of forwards where you swap one payment for another.
▪ e.g. Interest Rate Swap [receive fixed a 5-year rate but pay floating 90
Day Rate]
• Option Contract
o The right but not the obligation to buy or sell a good.
▪ e.g. shares or property
Derivatives Uses
• Hedging
o Risks are present through already existing exposure to changes in:
oodit pies, iteest ates, ehage ates, euit pies, et…
o Derivative securities provide an efficient approach to hedging risk.
o For example,
▪ a wheat farmer concerned about a fall in wheat prices could hedge
this risk by selling his anticipated crop forward.
▪ Because the farmer now has a set price, he is no longer exposed to
movements in the wheat price (both good and bad),
▪ but this does not mean that they have eliminated all risk, e.g. crop
failure.
• Speculating
o By trading derivatives you can gain a large exposure to a future outcome with
a relatively small outlay.
• Arbitrage
o Searching for mispricing of assets across markets and securities, and trading
to take advantage of the mispricing – e.g. buy the lower and sell the higher
(riskless)
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Forwards
• Forward contract
o Performed privately between two parties.
o It is a contract made today to be performed at some set time in the future at
a set price for goods of a particular quality delivered to a set location.
o The transaction can be tailored to suit particular requirements provided a
suitable counterparty can be found.
o Example:
▪ Forward contract between a farmer (seller) and a wheat buyer (buyer)
• Inception date (Now)
o Farmer and wheat buyer enter
into contract
• On delivery date (Then)
o Farmer delivers wheat
o Wheat buyer pays set price
• Potential Problems
o Finding a suitable counterparty
o Agreed forward price
o Counterparty default
Futures
• Futures contract
o An agreement made today to exchange a specified asset at a specified price
at a specified date in the future.
o They are highly standardised (set type, quality, size, maturity and delivery) so
that they can be exchange traded.
o Further, unlike the forward contract the exposure of buyers and sellers is to
the clearing house not to each other.
o Example: continued but with futures
• What are the advantages of futures contracts
o More liquid than forwards
o Market prices
o Exposure is to the exchange
• What are the disadvantages of a futures contract
o Difficult to exactly match quantity, quality, delivery date, etc...
▪ While not perfect, futures still provide a good hedge as return on
futures and physical are highly correlated
o Exchange manages its exposure to buyers and sellers by
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▪ Requiring an initial deposit; margin account
▪ Posting daily gains and losses to margin account; marking to market.
▪ If margin account drops below predetermined level (maintenance
margin), buyer or seller receives margin call advising to deposit
additional funds to margin account.
▪ If margin call is ignored, exchange will close position
• Additional Information on Futures
o You cannot choose to let the contract lapse.
▪ A futures contract is an obligation
o Very few contracts go to delivery
▪ They are closed out and cash adjustments made
▪ Closing out means taking the opposite transaction and paying or
receiving the difference in buying and selling price in cash
▪ If you originally bought January wheat then you sell January wheat to
close out the position.
▪ Why do this?
• Hedging with futures, example
o Its Ma 6 ad a NSW heat fae atiipates a op of , eti
tonnes in January 2017. The spot price of wheat is $260 per tonne while the
January 2017 futures contract is quoted at $272.
o Complete the following:
▪ Why would the farmer hedge?
▪ If they hedge,
• Do they buy or sell Wheat Futures?
• Which contract?
• How many contracts?
• What, when and where?
• Should they deliver on the contract or simply close out?
▪ What is the faes total etu he
• The price of wheat falls to $220 per tonne in January.
• The price of wheat increases to $320 per tonne in January.
• Why would the farmer hedge?
o eause thee oeed aout heat pies fallig. Hedgig ith futues
should eliminate most of this price risk.
• Which contract?
o the January contract
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Document Summary
Day rate: the right but not the obligation to buy or sell a good, e. g. shares or property. Forwards: forward contract, performed privately between two parties. Inception date (now: farmer and wheat buyer enter into contract, on delivery date (then, farmer delivers wheat, wheat buyer pays set price, potential problems, finding a suitable counterparty, agreed forward price, counterparty default. If margin account drops below predetermined level (maintenance margin), buyer or seller receives margin call advising to deposit additional funds to margin account. If you originally bought january wheat then you sell january wheat to (cid:858)close out(cid:859) the position: why do this, hedging with futures, example. It(cid:859)s ma(cid:455) (cid:1006)(cid:1004)(cid:1005)6 a(cid:374)d a nsw (cid:449)heat fa(cid:396)(cid:373)e(cid:396) a(cid:374)ti(cid:272)ipates a (cid:272)(cid:396)op of (cid:1005),(cid:1004)(cid:1004)(cid:1004) (cid:373)et(cid:396)i(cid:272) tonnes in january 2017. The spot price of wheat is per tonne while the. Wheat futures: sell, simple rule is do in the futures market now what you plan to do in physical market later, for example, when hedging.