1. 1 Forward and Future Chapter 25

2. 2 A Forward Contract An legal binding agreement between two parties whereby one (with the long position) contracts to buy a specified asset from the other (with the short position) for a specified price known as forward price, on a specified date in the future (delivery or maturity date). Forwards vs. Options Unlike options, forward contracts represent an obligation (rather than a right) on behalf of both sides of the contract to execute the trade on maturity.

3. 3 Future Contracts A future contract is like a forward contract: It specifies that a certain asset will be exchanged for another at a specified time in the future at a price specified today. No money changes hands between the long and short parties at the initial time the contracts are made. Only at the maturity of the futures (or forward) contract will the long party pay money to the short party and the short party will provide the asset to the long party. A future contract is different from a forward: Futures are standardized contracts trading on organized exchanges with daily resettlement (“marking to market”) through a clearinghouse.

4. 4 Margin Requirements For Future Contracts Initial Margin Requirement When future contracts are purchased, the purchaser does not have to put the full amount of the purchase price; Rather, investors are require to post an initial margin. Both the long and the short parties must deposit money in their brokerage accounts. It is typically 10% of the total value of the contract at initiation It is not a down payment, but instead a security deposit to ensure the contract will be honored.

5. 5 Example: Company A has just taken a long position in a future contract for 100 ounces of gold to be delivered in September. Company B has just taken a short position in the same contract. The futures price is $380 per ounce. The initial margin requirement for both parties is 10%. What is the initial dollar margin requirement for each? Answer: The total value of the contract at initiation: 100  $380 = $38,000 Initial margin requirement for Company A: 10%  $38,000 = $3,800 Initial margin requirement for Company B: 10%  $38,000 = $3,800

6. 6 Maintenance Margin: –Investors are required to maintain a certain value in the margin account, called maintenance margin. –The value of the contracts will be checked at the end of each business day, and margin account adjustments are made at that time. This is called “marking to market”. –If the value of the future contract declines, then the future contract purchaser is required to add additional funds to the margin account to retain the maintenance margin. –The more the contract value falls, the more money must be added.

7. 7 Marking to Market Summarizing the effects of marking to market on the margin account: Futures price risesFutures price falls Long in contractBalance IncreasesBalance Decreases Short in contractBalance DecreasesBalance Increases

8. 8 Marking to Market Example At t=0, Company A is long futures for 100 ounces of gold to be delivered in September. Company B is short in the same contract. The original futures price was $380 per ounce. They both deposited $3,800 initial margin in their account.  Assume at the end of t=1, the futures price goes up to $385. What is the new balance of their accounts at the end of that day (after marking to market)?  Assume at the end of t=2, the futures price drops to $350. What is the new balance of their accounts at the end of that day?

9. 9 For Company A: Long the future contract The rise of future price will lead to an increase in their account balance. Company A will be compensated for an increased future price, with the difference being deposited to his account. –The amount to be deposited: 100  ($385-$380) = $500. –The new balance in the account is: $3,800+$500 =$4,300 For Company B: Short the future contract The rise of future price will lead to a decline in their account balance. Company B needs to pay for an increased future price, with the difference being charged to her account. –The amount to be charged: 100  ($385-$380) = $500. –The new balance in the account is: $3,800-$500 = $3,300 t=1: When the futures price goes up to $385

10. 10 t=2: When the futures price drops to $350 For Company A: Long the future contract The decline of future price will lead to a decline in their account balance. The amount to be charged: 100  ($385-$350) = $3,500. The new balance in the account is: $4,300-$3,500 = $800 For Company B: Short the future contract The decline of future price will lead to a higher account balance. The amount to be deposited: 100  ($385-$350) = $3,500. The new balance in the account is: $3,300+$3,500 = $6,800

11. 11 Maintenance Margin Requirement Both the long and the short parties must maintain a balance in their brokerage margin accounts. Typically half of the initial margin requirement, or 5% of the total value of the contract at any time. Marking to market may result in the brokerage margin account balance falling below the maintenance margin requirement. This will trigger a margin call: the investor is required to bring the account balance back to the initial margin requirement percentage (typically 10%). Maintenance Margin Requirements and the Margin Call

12. 12 Example: At t=2, The balance in the company A’s margin account is: $800. The maintenance margin requirement is: 5%  100  $350 = $1,750. Thus, the balance in the margin account is below the maintenance margin requirement. A margin call is triggered to bring the balance in the margin account to the initial margin requirement percentage of 10%. The margin call would be: (10%  100  $350) - 800 = $2,700

13. 13 Who Needs Futures? Speculating with Futures A speculator is a person willingly accepting a risk because of the opportunity to profit from futures price movements. Hedging with Futures You may either need to purchase or sell the underlying asset in the future (e.g., a farmer selling his/her crops, or a manufacturer buying raw materials) –Go long (short) in the futures contract will let you effectively lock in the purchase (sale) price today.