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Forward and Futures Contracts

Forward and Futures Contracts. Definitions and examples. Definition. Future Contracts: call for the delivery of a given quantity of currency at a given date in the future, at a predetermined exchange rate.

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Forward and Futures Contracts

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  1. Forward and Futures Contracts Definitions and examples

  2. Definition Future Contracts: call for the delivery of a given quantity of currency at a given date in the future, at a predetermined exchange rate. Forward Contracts: call for the delivery of a given quantity of currency at a given date in the future, at a predetermined exchange rate.

  3. A comparison

  4. Marking-to-market Daily settlement of the margin account

  5. Exemplification You need Swiss francs in one week, but are afraid the franc will appreciate against the dollar. On Friday, you buy one futures contract on the Swiss franc (SFR 125,000) at US$ 0.75, maturing next Thursday. You hold the contract until maturity, and take delivery.

  6. Marking to market: taking delivery

  7. Analysis Your margin account: $625-$1,500-$1,625+$2,625+$750 = $875 You paid $94,625 for the SFRs on the spot You received a net $875 on margin The SFRs cost only $(94,625-$875) = $93,750, which amounts to $0.75/SFR, the rate you locked in at the beginning.

  8. Do you really need to take delivery? What if you took the offsetting position at maturity?

  9. Remark Due to marking-to-market, it makes no difference from a cash flow point of view whether you take delivery or take the offsetting position

  10. Profit from a futures/forward contract Long position: Spot price - Settlement price Short position: Settlement price - Spot price

  11. Forward/futures prices and expected spot prices Forward/futures prices are quoted by financial institutions Expected future spot prices cannot be directly observed

  12. Forward/futures prices and expected spot prices If, on average, hedgers go short and speculators go long: f < E(S) If, on average, hedgers go long and speculators go short: f > E(S)

  13. Relationship between spot and forward prices for foreign exchange Assume two-year rates in the US and Canada are 7% and 5% respectively. The spot rate is USD 0.62. The two-year forward rate USD 0.63.

  14. Arbitrage portfolio for an asset providing a known yield/return Arbitrage profit = USD 16.6

  15. Implication Eventually, investors would drive down the forward price and bid up the spot price of the US$

  16. Relationship between spot and forward/futures prices for an investment asset providing a known yield/return F0 = S0e(r-q)T Where q is the known yield/return provided by the investment asset q is the interest rate on the foreign currency.

  17. Summary Forwards and futures are very similar Futures are standardized for trading on organized exchanges Futures are subject to marking-to-market.

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