2 - Introduction to Forwards and futures

advantages and disagvantages of forward contract

advantages - customised - no initial/intermediate cash flows - able to make/take delivery of physical asset disadvantages - must bear credit risk of counterparty - negotiation costs - may be inconvenient to take asset delivery - no secondary market - some forward markets lack liquidity

what is a forward contract

agreements between two parties, the buyer and the seller, for the former to purchase an asset from the latter at a specific future date at a price agreed upon up-front. No money changes hands between the buyer and seller and, thus, a forward contract itself is not an asset, but merely, an agreement. Forward contracts are created in an over-the-counter (OTC) market. always delivered

what is a forward rate agreement. What do the parties settle

an agreement between two parties seeking to protect themselves against a future interest rate movement for a specified period at a contract rate. the parties settle the differential between the contract rate and the settlement rate.

Describe reverse cash and carry arbitrage F < S + C

buy futures at F, sell short in spot market and avoid C. Take delivery under long futures position, honour short sale. Profit = (St + C) - Ft > 0

What is long hedging

Have a short position in underlying asset worried about rise in price prior to actual purchase in spot market - taking a long position in a futures forward contract. Example, purchasers of raw materials. depositors making floating rate investments.

Key FRA points

OTC - traded by banks popular are 3 month and 6 month maturities. really extend beyond 2 years. fixed/floating interest rate swap is equivalent to a strip of FRA's. companies more comfortable using FRAs rather than interets rate futures to hedge interest risk

Describe cash and carry arbitrage, if F > S + c

sell futures at Ft, buy in spot market St and carry at cost c. Make delivery under short futures positions Profit = Ft - (st + c) > 0

What is the naieve hedging strategy

take a position in futures contract that is equal and opposite to your spot market position.

two important principles of futures and spot prices

- futures and spot prices move in parallel (arbitrage between spot and futures markets. Future and spot positions are substitutes) - futures and spot prices converge as expiration date is approached. (arbitrage between spot and futures markets on delivery date.) since c approaches 0 as t nears T

When are arbitrage opportunities for the F and S + C relationship

Abset when F = S + C

how would borrowers use FRAs to hedge interest rates

floating rate borrowers buy FRA's to hedge against rising interest rates

what is a futures contract

forward contracts, but trade on an organized exchange and are subject to special margin requirements and a daily settling of profits and losses rarely delivered (offset) or never (cash settlement)

what is short hedging

have a long position in asset worried about decline in price take a short position in futures contract Example. producers of raw materials borrowers raising floating rate loans.

what is open interest

total number of open long positions in a futures contract - rises as trading in contract gathers momentum - declines as expiration date approaches as people offset their positions