Forwardand

FuturesContracts

Forward Contracts

• Forward: obligation to buy/sell an underlying asset at a pre-specified expiration time and exercise price

• Position– Long = buy

• Payoff = (asset price at expiration) minus (exercise price)• (ST – K)

– Short = sell• Payoff = (exercise price) minus (asset price at expiration)• (K – ST )

• Typically, exercise price set so no premium

Forwards vs Futures

• Both are obligations to buy / sell in the future• Forward:

– Physical delivery or cash-settled

– Over the counter – can be tailored / customized

– Two-sided risk

• Futures:– Traded on organized exchanges– Standardized contracts; thus, potentially liquid– Daily settlement (marking to market)

• Reduces default risk: essentially, a series of one-day contracts

– Margins (performance bonds)– Exchange clearinghouse

Types of Contracts

• Agricultural commodities– Wheat, corn, soybeans– Farmer (supplier) can lock in sales price before

harvest (short futures)– Consumer (user) can lock in purchase price (long

futures)

• Other commodities– Metals, petroleum

• Financial assets– FX, stock market indices, interest rates

Example of Forward Payoff

• Ann agrees now to buy from Bill one barrel of oil, five months from now, for $20– Ann is in the “long” position– Bill is in the “short” position

• Assuming cash settlement, if the price of oil is $25 five months from now, who pays to whom, and how much?

• Assuming cash settlement, if the price of oil is $12 five months from now, who pays to whom, and how much?

Q: Forwards and Futures(From Exam FM Fin Econ Sample Questions)

Q: Forward Contracts(From Exam FM Fin Econ Sample Questions)

Q: Forward Profits and Payoffs(From Exam FM Fin Econ Sample Questions)

Q: Forward Price(From Exam FM Fin Econ Sample Questions)

Q: Forward Profit Calculation(From Exam FM Fin Econ Sample Questions)

Q: Forward Profit Calculation(From Exam FM Fin Econ Sample Questions)