Forward and Futures Contracts

Forward Contract

A contract conveying the obligation to buy or sell an asset at a fixed price (the forward price) at some future date. Cash is exchange only at the future date.

Commodity swaps

Agreement to exchange fixed quantity of a commodity at fixed times in the future.

Hedger

A hedger is an individual or institution using the future market to bet on future price movements in order to decrease the risk they bear.

Long hedger

A long hedger buys a future contract in order to guarantee the cost of some commodity in the future. Examples of long hedgers are a food processor purchasing soybean futures, Kodak purchasing silver futures, or any other firm buying futures on a commodity which is used as an input in a production process.

Risk Profile

A plot showing how the value of the firm is affected by changes in price or rate. It is the basic tool for identifying and measuring firm's exposure to financial risk.

Payoff profile

A plot showing the gains and losses that will occur on a contract as the result of unexpected price changes.

Variance (maintenance) margin?

Additional money to cover losses when the market moves the wrong way.

Swap contract

An agreement by two parties to exchange, or swap, specified cash flows at specific intervals in the future.

Commodity futures

An agreement to buy or sell a set amount of a commodity at a predetermined price and date. Buyers use these to avoid the risks associated with the price fluctuations of the product or raw material, while sellers try to lock in a price for their products. Like in all financial markets, others use such contracts to gamble on price movements.

Do derivatives increase or reduce risk?

Derivatives are generally used as an instrument to hedge risk, but can also be used for speculative purposes.

How do farmers use futures to reduce risk?

Farmers are insuring themselves against price going down. Lock in selling price.

Interest rate swaps

Firms wants to get fixed-rate loan, but can only get floating rate long. Another firm with opposite problem agrees to exchange loan payments.

Futures options

Future options are options on future contracts.

Are "wine futures" really futures?

Futures only in the sense you are getting it later. Because you are paying now it is not the same.

Cross hedging

Involves hedging an asset with contracts written on a closely related, but not identical, asset. (For example - Airlines hedge jet fuel costs using heating oil contracts)

Marking-to-Market

Mark-to-market valuations are performed at the end of each day to determine the unrealized profit or loss for each individual contract based on the contract price, the closing market price, the open quantity and the value date of the contract.

Price limits

Price limits are the amount the futures price is allowed to vary from day to day. For example, for widgets, futures may only be allowed to trade at futures prices withint $.20 of the previous day's closing futures price.

Short hedger

Sells a futures contract in order to guarantee the price received from the sale of some commodity in the future. Examples of short hedgers are farmers selling corn futures, ranchers selling cattle futures, mining corporations selling gold futures, and lumper selling lumber futures.

Currency swaps

Two parties exchange specific amount of one currency for specific amount of another at specific dates in the future.

Convenience yield

Unlike a spot purchase, a futures contracts gives no convenience yield, which is the value of being able to get your hands on the real thing.

Futures and futures options are traded in the U.S on the following exchanges

a. Chicago Board of Trade c. Coffee, Sugar & Cocoa Exchange g. New York Board of Trade

"Weather derivatives" traded on the Chicago Mercantile Exchange.

i. Based on monthly heating degree days in 10 U.S cities. ii. Based on month cooling degree days in 10 U.S cities

Financial futures

A futures contract on a financial product. Examples of financial futures include trading on currencies, stock indices, and Treasury securities. In a financial future, the counterparties agree to trade the underlying financial product at a certain time for a certain price. Some financial futures are settled in cash, especially if the underlying assets are indices. Financial futures may be traded like other futures.

When was the NYSE founded, by legend under the buttonwood tree?

1790s

Open margin accounts

Both the buyer and the seller of the futures contract must open margin accounts with their broker and deposit money to ensure that they can fulfill their contractual obligations.

Saddam futures

Buy contracts betting Saddam with be out of power. The price you pay today reflects the probability he'd be in power at the end of the month.

Circuit Breakers

Designed to give the markets a breather in cases of sharp price movements, curbs trading of futures or stocks at various trigger points. At certain points during the Friday the 13th drop, circuit breakers kicked in on the futures market, slowing trading at times. A circuit breaker that would have closed down the New York Stop Exchange wasn't tripped.

What is the difference between a hedger and a speculator?

Hedger buyers insurance against price going down. Speculator places a bet on price going up and assumes the risk. Hedger reduces risk.

Initial Margin

Requirement in brokerage account to settle initial marking to market.

Two forms of exchange at Expiration date

Short = seller, Long = buyer 1. The party who "short" the forward contract delivers delivers the commodity and the party who "long" the contract pays the forward price ($1620). 2. The settle up in cash: if the forward price is "up" ("down") the "long" ("short") side wins.

Transaction exposure

Short-run financial risk that arises from the need to buy or sell at uncertain prices or rates in the near future. Firms are constantly finding new ways to hedge away transitory price changes.

Cash (or Spot) Price

The cash of sport price of a commodity or financial instrument is the price of that commodity or instrument agreed upon today for delivery immediately.

Forward and Futures Price

The forward price and the futures price of a commodity or financial instrument are prices agreed upon today for the delivery of a commodity or financial instrument at some time in the future. The forward price and the futures price of an asset need not to be equal.

Economic exposure

The long-term financial risk arising from permanent changes in prices or other economic fundamentals.

Doubling up

When executing a double-up strategy, the investor believes that the latest adverse price fluctuation is only temporary and will shortly correct itself. To capitalize on the price reversal, the investor amplifies his or her current position. Doubling up is a risky strategy, but it can yield large returns.

Futures Contract

a. A futures contract is a contract conveying the obligation to buy or sell property at a fixed price (the futures price) at some future date. b.The seller decides which day during the delivery month to deliver the asset. c. The purchaser agrees to buy the asset at the futures price during the delivery month. The seller agrees to sell the asset at the futures price during the delivery month.

Derivatives

a. A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. b. Can be used as insurance against market speculation c. Options, Forwards, Futures - Afford the opportunity to transfer risk

On United States exchanges, futures contracts and futures options are traded on:

a. Agriculture products b. Chemicals - Benzene c. Energy products - coal, oil, natural gas d. Financial Products - Equity, Debt, Foreign Exchange Rates e. Metals f. Weather

3 Important functions of capital markets:

a. Facilitate the transfer of capital between parties with projects and little cash and parties with cash and few investment opportunities (e.g provide financing for entrepreneurs) b. Facilitate the transfer of Risk (Farmers sell futures to lock in price) c. Facilitate the process of price discovery (GM buys futures)

Speculator - Who might use futures or forwards to speculate? How?

A speculator is an individual or instituions betting on future price movements through the futures market and thereby absorbing risk. If a speculator trades with a hedger, the speculator absorbs the risk a hedger eliminates. Someone who thinks they can guess the direction of the market.

Arbitrage

The simultaneous sale and purchase of the same asset in separate markets, generating profit without risk or net investment. In practice, index arbitrage occurs when the futures price rises above (falls below) its fair value relation to stock prices, prompting the purchase (sale) of stocks in an index and the sale (purchase) of the futures contract that underlies the index. The effect of index arbitrage is to return stock and futures prices to their fair value relation.

Program trade

The simultaneous trade of a basket of stocks. Program antedates computer trading. The primary role of computers in program trading concerns the Designated Order Turnaround system at the NYSE. DOT allows a trader to send orders to many trading posts simultaneously, thereby lowering trading costs and speeding execution.