Tutorial 1

Introduction to Derivatives: Futures

and Forward contracts
Consultation hours
 Dr. Giang Hoang
 Email: [email protected]
– Please include BFF3751 in your email title
for a timely response

 Consultation hours: 1.00-2.00 PM

Tuesdays

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Question 3
 You are a star trader and observe two events:
1. A severe drought in Brazil, the world largest orange
juice producer
2. A deadly citrus virus resulting in decrease in orange
crops in the US
 Frozen concentrated orange juice (FCOJ) futures
contract
– One FCOJ contract covers 15,000 pounds of orange juice
solids.
– Standard delivery months are Jan, Mar, May, July, Sep and
Nov.
 Your action: Traded 10 long Sep-21 FCOJ futures
contracts at F = 200 cents/pound
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Question 3a.
(a) Having entered 10 long FCOJ contracts, what are your
obligations? What is the risk you face that might keep you
awake at night?

 By entering a long futures contract, we have an

obligation to buy the underlying asset at the contract
price (F) on the specified delivery date.
 In this case, we are long ten FCOJ futures contracts.
Futures contracts are highly standardised. Each FCOJ
contract covers 15,000 pounds of orange juice solids.
• Since we have ten contracts, we are obliged to
purchase 150,000 pounds of orange juice in
September 2021 at a fixed price of 200 cents per
pound.
• Therefore, the purchase will cost us: 150,000 × $2 =
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$300,000.
Question 3a.
 Potential risk:

We went long because we are speculating that orange

juice prices will rise.  
 The danger is that the predicted price rise does not

eventuate. If orange juice price falls to say 150c, we are

obliged to buy OJ at 200c per pound and it will only be
worth 150c. In other words, the danger with a long
position is that prices will fall.

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Question 3b:
(b) The futures price for Sep-21 FCOJ has risen sharply to 230
cents per pound. You jump on the computer and sell-to-close 10
Sep-21 FCOJ futures. Calculate your profit from trading these
orange juice futures

• The FCOJ futures traded on the ICE can be physically delivered

– NOT POPULAR. The vast majority of futures contracts are not
physically delivered. Rather, the trader closes out by entering an
equal and opposite position.
• In our case, we can close out any time we want between now
and September 2021. The question says that, once price hits
230c, we close out and take the profit. 

Opening trade: Long ten Sep-21 FCOJ contracts: 10 × 15,000 × 200 USD 300,000

Closing trade: Short ten Sep-21 FCOJ contracts: 10 × 15,000 × 230 USD 345,000

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Profit USD 45,000
 Question 3c.
 To understand the possible payoffs from long futures (and
forward) positions, complete the table below. Plot you
answer to see the payoff diagram
Calculate profit or loss if Sep-21 FCOJ futures
price is:
 
100 125 150 175 200 225 250 275 300

Profit or loss -150k -112.5k -75k -37.5k nil +37.5 +75k +112.5 +150
on ten long k k k
FCOJ futures

Showing specific calculations for F=100

Opening position: 10 × 15,000 × 200 = $300,000
Closing position: 10 × 15,000 × 100 = $150,000
=> Profit/loss: $150,000 – $300,000 = -$150,000 7
Payoff diagram
 (See Answer 1 on Moodle)

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Question 4
 Today is 1 July and the spot exchange rate between
Australian dollars and Swiss francs is AUD 1.00 = CHF
0.74. That is, one AUD buys you 0.74 Swiss franc. Your
local bank quotes a six-month forward rate at AUD 1.00 =
CHF 0.7450
 (a) If I talk about the CHF ‘strengthening’ relative to the
AUD, what does this mean? That is, give me an example
of an exchange rate quote after the CHF has
strengthened.
– The convention is to quote an exchange rate as AUD 1.00
buys X foreign dollars (this is referred to as an indirect
quote). For example, AUD 1.00 = CHF 0.74.
– How much does it cost to buy one Swiss franc? AUD
1.3514. This is a direct quotation: CHF 1.00 = AUD 1.3514
– This practice also makes it much easier to understand the
jargon of currencies ‘strengthening’ and ‘weakening’.
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 Question 4a
(a) If the CHF strengthens, it becomes more expensive to buy.
Buying CHF 1.00 will cost more than AUD 1.3514. For
example, the cost of one CHF might be AUD 1.40. In such a
case, the quoted exchange rate after strengthening is thus
1/1.40 = 0.7143. (i.e. AUD1.00 = CHF 0.7143)

So you can see why the indirect quoting convention is

counter-intuitive. CHF quotes have gone from 0.7400
down to 0.7143, yet this is in fact a strengthening of the
CHF.
 
In contrast, if we use direct quotes, it is intuitive that the
cost of a CHF going from 1.3514 up to 1.4000 is a
strengthening.
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 Question 4b
(b) If we are speculating that the CHF will strengthen, so we want
a long position in the CHF. Long positions make money when
the price of the underlying asset rises.

  Even ignoring the availability of a forward contract, we could

speculate by taking a long position in CHF (i.e., just buy some
Swiss francs today at cost of AUD 1.3514). We hold the CHF,
hope they strengthen, then sell them at the higher price (i.e.,
convert them back to AUD). 

  

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 Question 4b
 However, the question wants us to speculate using the forward
contract.

 Again, we would take a long forward contract on CHF at the

six-month rate of 0.7450.
 Entering a long forward contract at 0.7450 gives us the right to
buy Swiss francs in six months’ time at a fixed price of AUD
1.3423.  (AUD1.00 = CHF0.7450 or CHF1.00 = AUD1.3423)
 To profit from this speculation, we not only need the CHF to
strengthen, but to strengthen beyond the quoted forward rate
of 0.7450. This happens in part (d) and we do in fact profit.

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Question 4c
 The spot exchange rate at 31 December maturity is 0.80.
This represents a weakening of the CHF (thus, our
calculation below must show a loss). The quoted forward
rate for delivery on 31 Dec must also be 0.80 (else trivial
arbitrage opportunity – see Tutorial 1 Question 6).
 So the ‘price’ of a CHF is 1.2500 (AUD1.00 = 0.80 
CHF1.00 = 1.2500). We close out by shorting CHF 60,000
at this low price.
In July Enter long forward AUD80,538
contract:
CHF60,000*1.3423
In December Close out by AUD75,000
shorting forward
contract
CHF60,000*1.2500
Loss AUD5,538
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Question 4c
 Note: when we enter this long forward contract in July, no
money changes hands. It is just a contract which has a
notional value of $A80,538.
 Likewise, when we close out by shorting the contract, we
do not receive the notional value of $A75,000. The only
cashflow is us handing over $5,538.

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Question 4d
 The spot exchange rate at 31 December maturity is 0.70.
the CHF has strengthened considerably. This what we
were hoping when we entered a long forward on Swiss
Francs. The price of a CHF is AUD1.4286. ( CHF1.00
=1/0.70 = 1.4286AUD)

In July Enter long forward AUD80,538

contract:
CHF60,000*1.3423

In December Close out by AUD85,716

shorting forward
contract
CHF60,000*1.4286
Profit AUD5,178

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Question 5
 Plan: A trip at the end of Semester 2.
 Today as of 1 August: AUD 1.00 = EUR
0.6800
 Budget: EURO 10,000
 You fear that the Australian Dollar might
weaken (i.e. EURO might strengthen)
between now and December, thus
impacting on the quality of your vacation

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Question 5a
 (a) Assume that you decide to do nothing about your
exposure to exchange rate risk. In December, the day
before your departure, you visit the bank and ask to buy
EUR10,000 for your holiday. Assume that the spot
exchange rate in December is AUD 1.00 = EUR 0.5000.
How much will the EUR10,000 cost you?

 This part illustrates the danger of remaining exposed to

exchange-rate movements (i.e., being unhedged). The AUD
has weakened relative to the Euro between August and
December.
 Back in August, one Euro cost AUD 1.4706. Now, one Euro
costs AUD 2.0000.
 So the EUR10,000 needed for your holiday cost you a lot
more. At the spot rate of 0.50, buying EUR 10,000 will cost
AUD 20,000 17
Question 5b
(b) Not wanting to risk the consequences of the AUD
weakening (i.e. EUR strengthening), you go to the bank
today (1st August) and buy EUR10,000 at the spot rate of
0.6800. You put these Euros under your mattress and leave
them there until December. How much does your vacation
cost?

 If we purchase EUR 10,000 at today’s spot rate of 0.6800,

it will cost us AUD 14,706. (AUD1.00=EUR0.6800  EUR
1.00 = 1.4706)
 If the exchange rate did weaken to something like 0.50 in
part a, we would be very glad we bought the Euros early.
But this strategy isn’t ideal, in that we need to have
access to AUD 14,706 today and thus miss out on the
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potential interest we could have earned.
Question 5c
 The Commonwealth Bank in Melbourne CBD has a large
foreign exchange desk and they offer a forward contract
on Euros for delivery in December at a quoted price of
0.6823.
 You enter a long forward contract to buy Euros at the
quoted price. In December, you honour your obligation
under the long forward contract to buy EUR10,000. How
much does your vacation cost you?

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Question 5c
 By using a forward contract, we can lock in today the price
at which we can buy Euros in December, thus removing
any risk of exchange-rate movements.

 And doing this is better than (b) because we don’t need to

have any cash now. Since we intend to buy Euros in
December, we would enter a long forward contract
written on Euros. As soon as we do this, we know for
certain that, in December, the EUR 10,000 will cost us
AUD 14,656.

 And another good thing about this long forward contract is

that we don’t need any cash now. We merely need to have
AUD 14,656 in December to meet our commitment under
the forward contract.
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Question 5d
(d) Assume that forward contracts are too confusing for you. You
like the idea from part b of buying Euros now, but you don’t
exactly have the spare cash to be buying them so far in advance
of your trip. Instead, you do the following:

(i) calculate how much it will cost you to buy EUR 10,000 now at the spot
rate,
(ii) arrange a loan from the local bank at 2% p.a. continuously-compounded
interest so that you can buy the Euros now,
(iii) in December, you repay the balance of that loan in full. The effective cost
of your vacation is the payout figure on the loan. How much is it?

 To buy EUR 10,000 at today’s spot rate of 0.6800, we need

AUD 14,706. So we can borrow AUD 14,706 from a local
bank, convert them into Euros today at the spot exchange
rate, all ready for our vacation.
 Four months later, we repay the loan balance of AUD 14,804
(=14,706* e0.02x4/12 ) *21
Question 5e
(e) The approach in part d is clever but nonetheless
suboptimal in that, after you arrange the loan and buy EUR
10,000, you merely put those Euros under the mattress until
December. Obviously, you are missing out on potential
interest! Here’s a better plan.
 Go to a local bank today and borrow AUD14,560. With
this money, you convert them into Euros at the spot
exchange rate (0.6800).
 Next, you open a bank account somewhere in Europe and

deposit the Euros for a 4-month period from 1st August

through 1st December. The foreign bank account pays
you 3% p.a. continuously compounded on the deposit.
  How much money is in that European bank account in

December? What is the balance owing on your Australian

bank loan? What is the effective cost of your vacation
now? 22
Question 5e
 If we borrow AUD 14,560 today and use it to buy Euros at
the spot rate of 0.6800, this produces EUR 9,901 (14,560
× 0.68).

 Next, we deposit these Euros into our European bank

account to earn interest at 3% p.a. continuously
compounded. In four months’ time, this account has grown
to EUR 10,000 (=9901e0.03x4/12 ). So that’s our target
spending money for the vacation!

 Back home, our loan of AUD 14,560 has grown to AUD

14,657 (=14,560* e0.02x4/12 ). So this is the effective cost of
the holiday.

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Question 5e
 Note that the vacation cost in part e is identical to the
vacation cost when a forward contract was utilised in
part c (with $1 rounding difference).
 In Lecture 3, we will see the same logic being used to
establish the fair price for currency forward contracts (i.e.,
factoring in the spot exchange rate and the interest rates
in the two countries). This is how banks determine forward
rates.

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