Financial Derivatives

Jie Zhu, CFA

Shanghai University

September 2022

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Forwards and Futures

Forwards – a deferred-delivery sale of an asset with sales price

negotiated today. Traded in OTC market.
Futures - similar to forwards but with feature formalized and
standardized contracts. Traded in exchanges.
Key di¤erence in futures:
1. Standardized contracts, which is help to increase liquidity
2. Marked to market
3. Settled daily, which mitigates credit risk

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Basics of Futures Contracts

A futures contract is the obligation to make or take delivery of the

underlying asset at a predetermined price.
Futures price – the price for the underlying asset is determined today,
but settlement is on a future date.
Available on a wide range of assets.
The futures contract speci…es the quantity and quality of the
underlying asset and how it will be delivered.
1. What can be delivered,
2. Where it can be delivered, and
3. When it can be delivered

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Basics of Futures Contracts

Long – a commitment to purchase the commodity on the delivery

date.
Short – a commitment to sell the commodity on the delivery date.
Futures are traded on margin.
At the time the contract is entered into, no money changes hands.
Pro…t to long when the contract matures = Spot price at maturity -
Original futures price
Pro…t to short the contract matures = Original futures price - Spot
price at maturity
The futures contract is a zero-sum game, which means gains and
losses net out to zero.

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Margins

Futures contracts are traded on margin.

A margin is cash or marketable securities deposited by an investor
with his or her broker
The balance in the margin account is adjusted to re‡ect daily
settlement
Margins minimize the possibility of a loss through a default on a
contract
Initial margin and maintenance margin. A trader has to bring the
balance in the margin account up to the initial margin when it falls
below the maintenance margin level

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Example

An investor takes a long position in 2 December gold futures

contracts on July 5
1. contract size is 100 oz.
2. futures price is US$1450
3. initial margin requirement is US$6,000/contract (US$12,000 in
total)
4. maintenance margin is US$4,500/contract (US$9,000 in total)

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A Possible Outcome

Day Trade Settle Daily Cumul. Margin Margin

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,450.00 12,000
1 1,441.00 −1,800 − 1,800 10,200
2 1,438.30 −540 −2,340 9,660
… … … … …
6 1,436.20 −780 −2,760 9,240
7 1,429.90 −1,260 −4,020 7,980 4,020
8 1,430.80 180 −3,840 12,180
… … … … …
16 1,426.90 780 −4,620 15,180

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Trading Mechanics of Futures Markets

Closing out a futures position involves entering into an o¤setting trade

Most contracts are closed out before maturity
If a futures contract is not closed out before maturity, it is usually
settled by delivering the assets underlying the contract. When there
are alternatives about what is delivered, where it is delivered, and
when it is delivered, the party with the short position chooses.
A few contracts (for example, those on stock indices and Eurodollars)
are settled in cash
It is becoming increasingly common for contracts to be collateralized
in OTC markets
They are then similar to futures contracts in that they are settled
regularly (e.g. every day or every week)

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Some Terminology

Open interest: the total number of contracts outstanding. It equals

to number of long positions or number of short positions
Settlement price: the price just before the …nal bell each day used for
the daily settlement process
Volume of trading: the number of trades in one day

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Convergence of Futures to Spot

No arbitrage requires that the futures price must converge to spot

price when the contract is at maturity

Futures
Price Spot Price

Spot Price Futures

Price

Time Time

(a) (b)

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Forwards vs. Futures

FORWARDS FUTURES
Private contract between 2 parties Exchange traded

Non-standard contract Standard contract

Usually 1 specified delivery date Range of delivery dates

Settled at end of contract Settled daily

Delivery or final cash

settlement usually occurs prior to maturity
Some credit risk Virtually no credit risk

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Foreign Exchange Quotes

Futures exchange rates are quoted as the number of USD per unit of
the foreign currency
Forward exchange rates are quoted in the same way as spot exchange
rates. This means that GBP, EUR, AUD, and NZD are quoted as
USD per unit of foreign currency. Other currencies (e.g., CAD and
JPY) are quoted as units of the foreign currency per USD.

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Long and Short Hedges

A long futures hedge is appropriate when you know you will purchase
an asset in the future and want to lock in the price
A short futures hedge is appropriate when you know you will sell an
asset in the future and want to lock in the price

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Argument of Hedges

In favor of hedge: Companies should focus on the main business they

are in and take steps to minimize risks arising from interest rates,
exchange rates, and other market variables
Against Hedge:
1. Shareholders are usually well diversi…ed and can make their own
hedging decisions
2. It may increase risk to hedge when competitors do not

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Example

Consider two manufacturers of gold jewelry, Company A and

Company B.
We assume that most companies in the industry do not hedge.
Company A decides to hedge the gold price risk and Company B
never hedges.
The following table shows the impact of price changes on both
companies:

Change in E¤ect on price E¤ect on pro…t E¤ect on pro…t

Gold price of gold jewelry of Company A of Company B
Increase Increase Increase None
Decrease Decrease Decrease None

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Basis Risk

The hedges in the example considered so far have been almost too
ideal.
In practice, hedging is not ideal due to following reasons:
1. The asset to be hedged may not be exactly the same the asset
o¤ered by the futures contract
2. The hedger may be uncertain to the exact date when the asset will
be bought or sold
3. The maturity of the futures contract may not exactly match the
hedging period.
We de…ne basis as the di¤erence between the spot and futures price.
Basis risk arises because of the uncertainty about the basis when the
hedge is closed out

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Basis Risk

De…ne
F1 : Initial futures price
F2 : Final futures price
S2 : Final asset price
Long hedge: If you hedge the future purchase of an asset by entering
into a long futures contract then

the cost of asset = S2 ( F2 F1 ) = F1 + Basis

Short hedge: If you hedge the future sale of an asset by entering into
a short futures contract then

price realized = S2 + (F1 F2 ) = F1 + Basis

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Choice of Contract

Choose a delivery month that is as close as possible to, but later

than, the end of the life of the hedge
This is to make sure that the futures position can be closed out before
hedging, and thus avoid the delivery, which will incur additional costs.
Example. It is June 8 and a company knows that it will need to
purchase 20, 000 barrels of crude oil at some time in October or
November. Oil futures contracts are currently traded for delivery
every month and the contract size is 1, 000 barrels. The company
therefore decides to use the December contract for hedging and takes
a long position in 20 December contracts. The futures price on June
8 is $18 per barrel. The company …nds that it is ready to purchase
the crude oil on November 10. It therefore closes out its futures
contract on that date. The spot price and futures price on November
10 are $20.00 per barrel and $19.10 per barrel. What is the e¤ective
price paid to purchase the crude oil?

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Rolling the Hedge Forward

Sometimes the expiration date of the hedge is later than the delivery
dates of all the futures contracts.
We can roll futures contracts forward to hedge future exposures
Initially we enter into futures contracts to hedge exposures up to a
time horizon
Just before maturity we close them out an replace them with new
contract re‡ect the new exposure

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Liquidity Issues

In any hedging situation there is a danger that losses will be realized

on the hedge while the gains on the underlying exposure are unrealized
This can create liquidity problems
One example is Metallgesellschaft which sold long term …xed-price
contracts on heating oil and gasoline and hedged using stack and roll
The price of oil fell.....

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