Futures Contract

Futures Contract

• It is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality for a price agreed upon today with delivery and payment occurring at a specified future date.

• The contracts are negotiated at a futures exchange, which acts as an intermediary between buyer and seller.

• The party agreeing to buy the underlying asset in the future, the "buyer" of the contract, is said to be "long", and the party agreeing to sell the asset in the future, the "seller" of the contract, is said to be "short".

Settlement - Physical Vs. Cash-settled Futures

• Physical delivery-the amount specified by the underlying asset of the contract is delivered by the seller of the contract to the exchange, and by the exchange to the buyers of the contract. Physical delivery is common with commodities and bonds.

Settlement - Physical Vs. Cash-settled Futures

• Cash settlement- Cash settled futures are those that could not be settled by delivery of the referenced item--for example, it would be impossible to deliver an index.

• The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.

Types of Contracts

• Equity Index• Interest rate• Grains• Livestock• Precious metals• Energy etc..

Margins/Performance Bond

• Initial Margin: Whenever a client (both buyer & seller) books future contract he is required to deposit a certain % of contract price(5-20%) as margin money which is called initial margin.

• Variation/Mark to Market margin : It is paid to/received from the client daily and is calculated on the basis of daily settlement price.

Margins/Performance Bond

• Maintenance Margin : it is set at a level slightly less than initial margin. The margin is required to be replenished to the level of initial margin, only if the margin level drops below the margin limit.

Futures Pricing

• When the underlying asset exists in plentiful supply- Arbitrage Pricing

(stock index futures, treasury bond futures, and futures on physical commodities when they are in supply (e.g. agricultural crops after the harvest)

• When the underlying asset is not in plentiful supply-Expectation Pricing

(on crops before the harvest or on Eurodollar Futures or Federal funds rate futures (in which the supposed underlying instrument is to be created upon the delivery date)

Expectation Pricing

• The Futures price should equal the expected spot price at the time of expiration

Futures=E(Spot)

The price of the futures is determined by today's supply and demand for the underlying asset in the future.

Arbitrage Pricing

• Assume that you could buy a barrel of oil for $80 today and the current futures price (for delivery 3 months from today) was $85. How could you exploit this discrepancy between the spot and futures price in a world of no transaction costs?

Arbitrage Pricing

• Now reconsider the above example in a more realistic setting. One contrast of oil is for 1000 barrels. What issues will you have when you try to take advantage of this pricing scenario?

Convenience Yield

• There may be a scenario where the actual physical asset may be preferred to the futures contract.

• In the case of stocks, this may be due to dividend payments.

• In the case of currencies, it could be due to interest rate differentials.

• In the case of commodities, it could be due a preference for the actual physical asset.

Arbitrage Pricing

F= Spot

F=Futures Price

i=interest rate

s=storage cost

c=convenience yield

t=time

Arbitrage Pricing

• i=2%, s=1%, c=.5%, t=3months=.25yrs

Spot=$80 F=?

F=$80

=$80.50

Futures price terms

• Contango- The futures price is higher than the current spot price

• Normal contango- the futures price is higher than the Expected spot price

• Backwardisation- The futures price is less than the current spot price.

• Normal Backwardisation- The futures price is less than the Expected spot price