Forward and Futures Contracts

Notes from Khanacademy – Forward and Futures Contracts:

Forward contract Introduction (3:10 mins):

• Forward contracts help reduces (hedges) volatility. i.e. The price of apples being sold fluctuates year on year from 10-30 cents a lb. This affects the farmer (supply) because some years he’s doing phenomenal but other years he can even cover cost. It also affects the buyer who makes apple pies (demand) because sometimes costs of the raw ingredients are over the price of his selling price and he would go out of business.
• Forward contract – When two parties agree (farmer and baker) to a set price, amount, and date that the farmer will sell and baker will buy the apples for in the future. It’s an OBLIGATION when the forward contract is created.

Futures Introduction

• Counterparty risk – What if the farmer can’t produce the set amount of apples OR what if the buyer can’t produce the money to buy all the apples he agreed to?
• What if either party is starting to have second thoughts about the agreement they went into. Can’t they sell their obligation to someone else?
• This is where a futures exchange/market comes about.
• Instead of having a huge contract of 1 million apples for $200,000, this future contract can be broken up into smaller STANDARDIZED contracts of 1000 apples for delivery at 11/15 for example. Now someone doesn’t need to buy all 1 million apples if they decided they didn’t want to, they could only buy 500,000 and use the exchange to have someone else buy the 500,000 apples.
• The Exchange guarantees that the contract will go through and he takes on the counterparty risk.

Motivation for the futures exchange

• The futures exchange is willing to take on the counterparty risk because they arbitrage the exchange between the seller and buyer. i.e. He tells the farmer that the buyer will buy for .20 cents and he tells the buyer that the farmer will sell for .22 cents. The exchange makes an arbitrage amount of .02 cents per lb.

Futures margin mechanics

• Margin is a feature created by the futures exchange to make sure that what the buyer and seller agreed upon for the amount, price, and delivery date is exactly what they’ll end up paying for on the delivery date.
• For example, if it costs .20 cents a lb of apples and a futures contract is in the size of 1000 lbs of apples, the cost of the futures contract is $200. But let’s say a couple days goes by and now another futures contract is set up and it’s now only $190 dollars for 1000lbs of apples.
• This is the reason futures exchange require an initial margin and a maintenance margin amount.
• The initial margin is how much both parties needs to put aside to ensure the exchange can ensure the agreed upon price of the contract is kept in place.
• The maintenance margin is the “trigger” amount. If the account goes below the maintenance margin for either the buyer or seller, they need to re-up and bring the margin account back to the initial margin amount.
• An initial margin amount is an arbitrary number the exchange requires the buyer and the seller to put into an account to create offset the market fluctuations in price of the apples. In our case, the futures contract is $200 but a better futures contract comes out at $190. In that case, the exchange will take $10 from the buyer and put it into the sellers account to “balance” the deal. If it goes down another $10, then another $10’s is given to the seller. The buyer needs to re-up the $20 dollars to maintain the margin amount.

Verifying hedge with futures margin mechanics

• When the delivery dates arrives, and lets say the current market price of apples is only $100 dollars, the buyer would have transferred $100 dollars through the margin account by the delivery date AND he would then “buy” the apples for only $100 dollars. The total amount the buyer ends up paying is the agreed upon $200 dollars total. $100 through margin and then another $100 at the market purchase price.

Futures and forward curves

• The spot price is the current price to purchase a commodity or asset
• Stocks are always bought at spot price
• When you refer to spot price it’s usually with commodity futures contracts or derivatives.
• Normal curves – A slightly upward sloping curve of the future prices of a commodity. It’s called “normal” because, in a futures market, the primary reason you want to lock in the spot price is because the future price of the commodity you wish to have will increase in demand thus increasing in price. You want to save money so you buy a futures contract.
• Inverted curves – Slightly downward sloping curve.
• Forward contract – A forward contract is very similiar to a futures contract but they are not traded over a futures exchange. They are considered to be transacted privately “over-the-counter.” They are also settled on the date of delivery.

Contango from trader perspective

• Contango –

Severe contango generally bearish

Backwardation bullish or bearish

Futures curves II

Contango

Backwardation

Contango and backwardation review

Upper bound on forward settlement price

Arbitraging futures contract

Arbitraging futures contracts II

Futures fair value in the pre-market

Interpreting futures fair value in the premarket