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Futures and Forwards

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  1. Futures and Forwards Kaitlin Santanna & Eva Budzynski

  2. What are futures and forwards? • Contract that allows agreeing to the price of something now for the delivery of it sometime later

  3. History of Futures and Forwards • Roots in the trading of raw material • Guarantee the sale and price of goods before transported to their destination • Can be traced back to Ancient Greece • Mid-17th century Holland and Japan • Trade began in 1851 in Chicago • Developed standardized trading characteristics

  4. Monetary History • United States • Chicago exchanges developed currency futures in 1970s to offset decreasing volume of agricultural futures - Chicago Mercantile Exchange(CME) • Largely ignored until 1975 when major increases in level and volatility of interest rates • Futures a good risk management tool • Hugely successful due to its easy trading volume and global accessibility to markets

  5. Forwards • Private contract between a buyer and a seller where the buyer agrees to buy and the seller agrees to sell a certain commodity • Delivery and payment occurs at a specified future date instead of immediately • Unique terms  Created by individual parties operating on OTC markets

  6. Forward Example • Before wheat farmer plants crop, makes deal with cereal company for delivery and purchase of 75,000 bushels for 1$/bushel • Actual exchange doesn’t occur until after crop is harvested • Both farmer and company reduce risk • Farmer: Protected against falling spot price • Cereal: Protected against rising spot price

  7. Forward Example • Harvest time - spot price higher/lower $1 • Risen to $1.35, farmer unhappy but company pleased • Dropped to $.75, vice-versa • In general, buyer is pleased if the agreed-upon price is lower than spot price and seller is happy if contract price is higher than the spot price

  8. Futures Markets • Similar to forwards, but some key differences • Exchange-traded legally on futures exchanges with clearing house • Common specifications for such as size, time and delivery dates • This standardization makes it easy to trade contracts with similar commodities • Value of contract depends on market price of underlying commodity in the spot market • Short life • No debt basis – Clearing house regulations

  9. Role of Clearing Houses • Since futures contract is transacted on exchange, traders use clearing house as a third party to the trade • Clear trades, guarantees performance, handles fulfillment through delivery • Clearing house counterpart to each transaction • Buyers and sellers create financial obligations not to each other, but to the clearing corporation

  10. Opening and Closing Transactions • A transaction in futures is identified as either “opening” or “closing” position • Opening • Initial buying/selling • Closing • Offsetting transaction • Delivering/receiving the commodity

  11. Entering an Agreement • Can’t back out once a contract is made • If want to, have to sell your part of the agreement • Buyer has to have good credit standing • U.S. Commodity Futures Trading Commission (CFTC) • Congress created in 1974 as an independent agency with the mandate to regulate commodity futures and option markets in the United States • Today it assures the economic utility of the futures markets by protecting market participants against fraud, manipulation, and abusive trading practices, and by ensuring the financial integrity of the clearing process

  12. Margins & Futures • Used to ensure both members have enough funds to cover their positions • Function of clearing house • Initial margin • Good-faith deposit, makes sure buyer has money at time of expiry • Depends on volatility of commodity and the futures market itself • Can be in the form of cash, stock or letters of credit from an approved bank

  13. Margins and Futures • Maintenance (aka Variance or Marking-to-market) margin • At the end of every trading day, the contract is marked to its present market value as calculated by the clearing house • If contract has increased in value that day, and the exchange pays this profit into the account • If declined, the exchange charges the account that holds the deposited margin • If the balance of this accounts falls below the deposit required to maintain the position, the trader must immediately pay additional margin (a "margin call") • Futures have cash flow implications during the life of the contract

  14. Hedging • The primary objective is to reduce the price risk of a current or potential cash position • Hedging is only a tool to achieve clearly defined risk management objectives • Benefits • Gives a more stable price for the product • Users of commodities are able to “lock-in” the future purchase price of an item with only a small “down payment”

  15. Hedging • Hedging affects risk because of the basis between the cash and futures position • Hedging reduces the price risk inherent in the total price variability of the cash instrument to the variability of the basis • Hedging can reduce the net variability to more than 80% • Occurs because the futures price change offsets the effect of the cash price change

  16. Hedging Diagler, R. T. (1993). Financial Futures Markets. Harper Collins College Publishers: New York.

  17. Hedgingand Risk • Hedging is used to control risk • Risk is described as price change, a change in the basis, and unanticipated price changes • The first step is to decide whether one wants to avoid unanticipated price changes • Hedging eliminates most of the effect of these price changes, but it also eliminates potential positive returns • One must decide whether hedging is appropriate in each situation

  18. Futures and Forwards Today • 75 futures and futures options exchanges worldwide • Most active futures contracts • Treasury Bonds (T-bond) – Bond market • Money markets • Equity index market • Soft commodities market • Foreign exchange market

  19. Foreign Exchange Market • Banks and other official institutions facilitate the buying and selling of foreign currencies • Became possible by the Bretton-Woods system in 1971that fixed the floating exchange rate • Chicago International Monetary Market (CIMM) introduced the first financial futures contract on international exchange in 1972 • Due to the success of futures markets in the U.S., in 1982 the London International Financial Futures Exchange (LIFFE) was founded • Among their many departments was foreign currency markets

  20. Foreign Exchange Market • FX transactions typically involve one party purchasing a quantity of one currency in exchange for paying a quantity of another • The price of one currency in terms of another is called an exchange rate • The market itself is actually a worldwide network of traders • No central headquarters but three main centers of trading are the UK, United States, and Japan

  21. Foreign Exchange Market • People use the FX because: • To earn short-term profits from fluctuations in exchange rates, • To protect themselves from loss due to changes in exchange rates, and • To acquire the foreign currency necessary to buy goods and services from other countries. • Hedging neutralizes the effect of currency fluctuations on sales revenue • Standardized contracts with specifications

  22. Futures v. Forwards Futures • Standardized terms; traded on an exchange • No default risk • Daily cash flows as prices change to guarantee performance of contract • Low cost • Can trade contract on an exchange with liquidity • Risk related to differences between standardized contract and security desired • All terms negotiable; private transaction • Default risk (thus participants must have good credit standing or post a deposit) • No cash flow requirements • Creating contract often costly because of intermediary’s profit • Cannot trade before delivery • No price variability or quality risk from negotiated contract Forwards

  23. Works Cited • Anderson, T. J. (1993). Currency and Interest Rate Hedging. New York Institute of Finance: New York. • Diagler, R. T. (1993). Financial Futures Markets. Harper Collins College Publishers: New York. • FinancialWeb (2009). Forwards contracts. Retrieved April 19, 2009 from http://www.finweb.com/investing/forward-and-futures-contracts.html. • Foreign exchange market (n.d.) Retrieved April 21, 2009 from Wikipedia: http://en.wikipedia.org/wiki/Foreign_exchange_market. • Futures contract. (n.d.) Retrieved April 19, 2009 from Wikipedia: http://en.wikipedia.org/wiki/Futures_contract. • Goss, B. A. (1986). Futures Markets: Their Establishment and Performance. New York University Press: New York. • Investopedia (2009). What is the difference between forward and futures contracts? Retrieved April 19, 2009 from http://www.investopedia.com/ ask/answers/06/forwardsandfutures.asp. • Poitras, G. (2006). Futures Markets and Forward Markets. Retrieved April19, 2009 from http://www.sfu.ca/~poitras/ futures.pdf. • Siegel, D. R. & Sigel, D. F. (1990). Futures Markets. Dryden Press: Orlando, Fl.