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Week 6 -FINC 4486

Week 6 -FINC 4486. Futures & Forwards. Futures. Futures contracts are bought through brokers on an exchange No direct interaction between the two parties Exchange clearinghouse oversees delivery and settles daily gains and losses Customers post initial margin account. Forwards.

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Week 6 -FINC 4486

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  1. Week 6 -FINC 4486 Futures & Forwards

  2. Futures • Futures contracts are bought through brokers on an exchange • No direct interaction between the two parties • Exchange clearinghouse oversees delivery and settles daily gains and losses • Customers post initial margin account

  3. Forwards • Forward contracts are negotiated directly between two parties in the OTC markets. • Individually designed to meet specific needs • Subject to default risk • No Clearinghouse involved

  4. 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

  5. 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)

  6. Margins • 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 reflect daily settlement • Margins minimize the possibility of a loss through a default on a contract

  7. Margin and Trading Arrangements Initial Margin- funds deposited to provide capital to absorb losses Marking to Market- each day the profits or losses from the new futures price and reflected in the account. Maintenance or variance margin- an established value below which a trader’s margin may not fall.

  8. Marking to the Market • Marking-to Market • The process that realizes all • gains and losses. • Settlement Price • The benchmark against which all • accounts are marked-to-market.

  9. Marketing to the Market Marking-to-Market Example: Transaction Settlement Commodity Price PriceChange Gasoline 64.00 65.50 1.50+ Heating Oil 58.00 56.00 2.00+ Gasoline 66.00 65.50 0.50- Crude Light 25.60 25.50 0.10- Electricity 21.00 19.90 1.10+

  10. Initial margin Maint. margin margin call Marking to Market Your balance time

  11. 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 • The Clearinghouse acts as a middle person and lessens the risk to participants

  12. Basis and Basis Risk • Basis - the difference between the futures price and the spot price • over time the basis will likely change and will eventually converge • Basis Risk - the variability in the basis that will affect profits and/or hedging performance

  13. Convergence of Futures to Spot (Figure2.1, page 20) Futures Price Spot Price Futures Price Spot Price Time Time (a) (b)

  14. Delivery • If a contract is not closed out before maturity, it usually settled by delivering the assets underlying the contract. • The party with the short position chooses the delivery terms

  15. 97%-98% OF ALL FUTURES ARE NOT DELIVERED ONLY 2%-3% OF THE CONTRACTS TRADED ARE DELIVERED! EXAMPLE: IN 1990: 719,000 CRUDE OIL NYMEX CONTRACTS WERE ACTUALLY DELIVERED OUT OF 23 MILLION: ABOUT 3.126%

  16. A story of unwanted hogs • A new MBA hired at the futures desk at Merrill Lynch was long one hog future. He intended to sell the future, but by mistake bought another one – so he was long two hog futures contracts upon expiration. • In an attempt to cover his grave error, he intended to go and take delivery of the hogs and simply sell the hogs at auction the same day • Unfortunately, there was no hog auction until the next week, so the young MBA was stuck with all those hogs to house and feed for a week!!!!

  17. Oh No!!!!! • What to do with all those hogs!!!

  18. Forward Contracts • An agreement to buy or sell an asset at a certain time in the future for a certain price. • No daily settlement. • NO Clearinghouse • At the end of the life of the contract one party buys the asset for the agreed price from the other party.

  19. 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

  20. The Forward Price • The forward price for a contract is the delivery price that would be applicable to the contract if were negotiated today • The forward price may be different for contracts of different maturities

  21. Forward Contracts vs Futures Contracts TABLE 2.4 (p. 34) 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 maturity Settled daily Delivery or final cash Contract usually closed out settlement usually occurs prior to maturity

  22. Difference between Forwards and Futures • An over-the-counter (OTC) transaction resembles a privately negotiated contract between two firms. • Exchange traded derivatives are standardized contracts with the terms established by the exchanges. Exchange traded derivatives tend to be more liquid

  23. Futures Exchange Short Long Intention to Accept Delivery Intention to Make delivery Clearinghouse Matches Seller with Buyer Delivery Seller Buyer Payment Deposits margin Deposits full margin Clearing Broker Clearing Broker

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