2.1 Mechanics of Futures and Forward Markets

2.2 Futures Contracts Available on a wide range of underlyings Exchange traded Specifications need to be defined: - What can be delivered, - Where it can be delivered, & - When it can be delivered

2.3 Example of a Futures Trade An investor takes a long position in 2 December gold futures contracts on June 5 - contract size is 100 oz. - futures price is US$400 - margin requirement is US$2,000/contract (US$4,000 in total) - maintenance margin is US$1,500/contract (US$3,000 in total)

2.4 A Possible Outcome Table 2.2, Page 24 DailyCumulativeMargin FuturesGain AccountMargin Price(Loss) BalanceCall Day(US$) ,000 5-Jun397.00(600) 3, Jun393.30(420) (1,340) 2,6601, Jun387.00(1,140) (2,600) 2,7401, Jun (1,540) 5, = 4,000 3,000 + = 4,000 <

2.5 Other Key Points About Futures They are settled daily Closing out a futures position involves entering into an offsetting trade Most contracts are closed out before maturity

2.6 Some Terminology Open interest: the total number of contracts outstanding - equal to number of long positions or number of short positions Settlement price: the price just before the final bell each day - used for the marking to market process Volume of trading: the number of trades in 1 day

2.7 Questions When a new trade is completed what are the possible effects on the open interest? Can the volume of trading in a day be greater than the open interest?

2.8 Regulation of Futures Regulation is designed to protect the public interest Regulators try to prevent questionable trading practices by either individuals on the floor of the exchange or outside groups

2.9 Accounting & Tax If a contract is used for - Hedging: it is logical to recognize profits (losses) at the same time as on the item being hedged - Speculation: it is logical to recognize profits (losses) on a mark to market basis Roughly speaking, this is what the treatment of futures in the US & many other countries attempts to achieve

2.10 Forward Contracts A forward contract is an agreement to buy or sell an asset at a certain time in the future for a certain price - There is no daily settlement. At the end of the life of the contract one party buys the asset for the agreed price from the other party

2.11 How a Forward Contract Works The contract is an over-the- counter (OTC) agreement between 2 companies No money changes hands when first negotiated & the contract is settled at maturity The initial value of the contract is zero

2.12 The Forward Price The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today (i.e., it is the delivery price that would make the contract worth exactly zero) The forward price may be different for contracts of different maturities

2.13 Example Table 2.7, Page 42 May 8: a company enters into a LONG forward contract to BUY US$/£ in 90 days August 6: the exchange rate is US$/£ In accordance with the contract terms, the company pays US$1,838,100 & receives £1,000,000; The company’s profit is US$21,900 since the sterling can be immediately sold for US$1,860,000

2.14 Profit from a LONG Forward Position Profit Price of Underlying at Maturity

2.15 Profit from a SHORT Forward Position Profit Price of Underlying at Maturity

2.16 Forward Contracts vs Futures Contracts Private contract between 2 partiesExchange traded Non-standard contractStandard contract Usually 1 specified delivery dateRange of delivery dates Settled at maturitySettled daily Delivery or final cash settlement usually occurs Contract usually closed out prior to maturity FORWARDSFUTURES TABLE 2.6 (p. 39)

2.17 Forward Price vs Futures Price In theory, the futures price for a contract should be almost the same as the forward price for a contract with the same maturity on the same asset.