Forward and Futures Contracts

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) (S T – K) –Short = sell Payoff = (exercise price) minus (asset price at expiration) (K – S T ) 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)