Classnote 14, Forward Contracts,
Forward/futures/hedging readings: Ross Ch 24
Foreign currency exchange readings, Ross Ch. 21
Make sure you copy someone’s notes for diagrams
• Forward contracts are one-to-one with not central market.
• In a forward contract the price is fixed in the beginning.
• Futures contracts are forward contracts that are traded on an exchange
• Futures are exchange traded forwards.
1 Forward Contract: It is October 2010 and the spot price of wheat is currently $3.10 per
bushel. Mrs. Bull signs (now) a Forward Contract with Mr. Bear for the delivery of 1 bushel
of wheat in December 2010 at a Forward Price of $3.20. Mrs. Bull takes the long (buying)
position, Mr. Bear takes the short (selling) position. Neither party has an underlying position
in (or need for) wheat. This is just a toy example to show payoffs at maturity and overall
profits/losses to each party if the Dec 2010 spot price of wheat ends up at:
a) 2.60=-60 b) $3.10 c) $3.20 d) $3.30=10 c e) $3.60 = payoff
will be 40 cents
• The overall profits or losses will be the same as the payoff because there is no
• Both parties have the obligation here to buy/sell.
• There is no exercise price here either.
• The graph will always be a straight line.
• Mr. Bear’s payoff will be the opposite of Mrs. Bull’s; so his graph will be the
opposite of hers, so that they add up to 0; he loses whatever she’s making.
$3.20 Wheat Spot Price (Dec.
‘Spot’ Contracts, Forward Contracts
• Forward contracts=agreement now, delivery in future.
Spot prices, Forward prices
• A forward price makes sense with a particular date attached to it.
What premium is paid for a Forward contract? By whom?
3 Who has an option? Who has an obligation?
• No one has option
• Everyone has obligation
4 It is October 2010 and the spot price of wheat is currently $3.10 per bushel. Mr. Baker
needs to buy 1 bushel of wheat on 31 Dec 2010. Show his cost of wheat if the Dec 2010
wheat spot price turns out to be: a) $2.60 b) $3.10 c) $3.20 d) $3.30 e)
How can Mr. Baker ‘hedge’ his cost of wheat? What Forward strategy can he follow? If he
follows this strategy, what are his payoffs at maturity from the contract, his overall net
profits/losses from the contract, and his net effective hedged cost of wheat (given his
• He’s short wheat because he needs wheat.
• We need to first identify his risk.
• The payoff here with the contract will be a linear function as well.
• He’s got a liability to buy wheat.
• If the wheat price goes up, it’s good for him, and when its less than 3.20, it’s bad for
• This is due to opportunity cost.
Wheat Spot Price (Dec. 2010)
6 Compare the above outcomes to the outcomes from a wheat option hedge strategy
(classnote 11, pg 5, 6, strike=$3.20, call option premium $0.12)
• 3 options
o Do nothing, run business risk speculating; avoiding derivatives.
o Big difference between option and forwards, is the premium and the option to
continue or not.
o If you want to be certain about your costs, forwards are better; your cost will
always be the same with it.
o Option’s advantage is that you can walk away
o Safest, most certain forward; riskiest do nothing; options in the middle.
o Make sure you know how to show hedging through these graphs for exams.
Who might buy a forward contract on wheat?
• A hedger; and also needs wheat
• Or a bullish speculator who wants to bet on the price
7 Who might sell a forward contract on wheat?
• Person who has wheat hedger
• Bearish speculator who wants to bet on the price
How is the Forward Price determined?
What factors affect the forward price?
• Supply and demand
• Attached to the spot price
Are Forward Prices of commodities usually higher or lower than Spot Prices?
• In general, forward prices are higher than spot prices, due to time value of money
(main reason); small reasons would be storage costs.
• In general, Forward price should be future value of spot price
Which party is potentially worried about Counterparty risk?
8 ‘Closing Out’: In October, Mrs Bull had bought a December Wheat Forward Contract at
In November the December Forward price of wheat has changed to $3.50. Mrs Bull
decides to ‘close out’
• In order to close out, she can short the forward at 3.50
• Short the December wheat forward.
• There’s no fixed exercise price.
• short with 3.20
• long wit