Future and Forwards

Chapter 5
Forwards and Futures

Road Map
Part A Introduction to finance.
Part B Valuation of assets, given discount rates.
• Fixed income securities.

• Common stocks.
• Forwards and futures.
• Options.
Part C Determination of discount rates.
Part D Introduction to corporate finance.
Main issues
• Forwards and Futures
• Forward and Futures Prices
• Hedging Financial Risk Using Forwards/Futures

5-2 Forwards and Futures Chapter 5
Contents
1 Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . 5-3
2 Futures Contracts . . . . . . . . . . . . . . . . . . . . . . . 5-4
3 Forward and Futures Prices . . . . . . . . . . . . . . . . . . 5-7
3.1 Commodities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-8
3.2 Financials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-11
4 Hedging with Forwards and Futures . . . . . . . . . . . . . . 5-15
4.1 Hedging with Forwards . . . . . . . . . . . . . . . . . . . . . . . 5-15
4.2 Hedging with Futures . . . . . . . . . . . . . . . . . . . . . . . . 5-16
4.3 Basis and Basis Risk . . . . . . . . . . . . . . . . . . . . . . . . 5-20
4.4 Minimum Variance Hedge . . . . . . . . . . . . . . . . . . . . . . 5-22
5 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 5-24
15.407 Lecture Notes Fall 2003

c Jiang Wang
Chapter 5 Forwards and Futures 5-3
1 Forward Contracts
Definition: A forward contract is a commitment to purchase at a
future date a given amount of a commodity or an asset at a price
agreed on today.
agreement settlement
-
0 T time
• The price fixed now for future exchange is the forward price.
• The party with a “long position” will be the buyer of the

underlying asset or commodity.
Features of forward contracts:

• custom tailored
• traded over the counter (not on exchanges)
• no money changes hands until maturity
• non-trivial counter-party risk.
Example. Consider a 3-month forward contract for 1,000 tons

of soybean at a forward price of $165/ton. The long side is
committed to buy 1,000 tons of soybean from the short side in
three months at the price of $165/ton.

c Jiang Wang Fall 2003 15.407 Lecture Notes
2 Futures Contracts
Forward contracts have two limitations:
(a) illiquidity
(b) counter-party risk.
Futures contracts are designed to address these two limitations.
Definition: A futures contract is an exchange-traded, standard-

ized, forward-like contract that is marked to the market daily.
This contract can be used to establish a long (or short) position
in the underlying asset.
Features of futures contracts:
• Standardized contracts:
(1) underlying commodity or asset
(2) quantity
(3) maturity.
• Exchange traded
• Guaranteed by the clearing house — no counter-party risk
• Gains/losses settled daily
• Margin account required as collateral to cover losses.

c Jiang Wang
A Forward Contract
A Futures Contract

Example. Yesterday, you bought ten December live-cattle con-

tracts at CME, at a price of $0.7455/lb.
• Contract size 40,000 lb.
• Agreed to buy 400,000 pounds of live cattle in December.
• Value of position yesterday:

(0.7455)(10)(40, 000) = $298, 200.
• No money changed hands.
• Initial margin required (5%-20% of contract value).
Today, the futures price closes at $0.7435/lb, 0.20 cents lower.

The value of your position is
(0.7435)(10)(40, 000) = $297, 400
a loss of $800.
• Standardization makes futures liquid.
• Margin and marking to market reduce default risk.
• Clearing-house guarantee reduces counter-party risk.
Forward and futures contracts are derivative securities because

• payoffs determined by prices of the underlying asset
• zero net supply.

c Jiang Wang
3 Forward and Futures Prices

Question: What determines forward and futures prices?
Answer: Forward/futures prices are linked to spot prices.
Contract Spot at t Forward Futures

Price St F H
Ingnoring differences between forward and futures, we have
F H.
Two ways to buy the underlying for date T :
1. Buy forward or futures contract of maturity T .
2. Buy the underlying now and store it until T .
Difference between buy-and-store from forward/futures:
a. Cost of storing (for commodities)
b. Benefits from storing

• Convenience yield (for commodities)
• Dividends (for financials).
By arbitrage, the costs of these two approaches must equal:
F H = (1 + rF)S0 + FV (net cost of storing).

3.1 Commodities
1. Gold.
• Easy to store—negligible cost of storage.
• No dividends or benefits.
Two ways to buy gold for T :
• Buy now for S0 and hold until T .
• Buy forward, pay F and take delivery at T .
No-arbitrage requires that
F = S0(1 + rF)T H.
Example. Gold quotes on 2001.08.02 are

• Spot price (London fixing) $267.00/oz
• October futures (CMX) $269.00/oz.
The implied 2-month interest rate is rF = 4.58%.

c Jiang Wang
2. Gasoline.
• Costly to store.
• Additional benefits, convenience yield, for holding physical
commodity (over holding futures).
• Not held for long-term investment (unlike gold), but mostly
held for future use.
Let the percentage holding cost be c and convenience yield be
y.
We have
F = S0 [1 + rF − (y − c)]T
= S0(1 + rF − y)T
H
where
y = y − c
is the net convenience yield.
Example. Gasoline quotes on 2001.08.02: spot price is

0.7760, Feb 02 futures price is 0.7330, and 6-month interest
rate is 3.40%.
Annualized net convenience yield is: y = 14.18%.

For commodity futures:
1. Contango means:
(a) spot prices are lower than futures prices, and/or
(b) prices for near maturities are lower than for distant.
2. Backwardation means:
(a) spot prices are higher than futures prices, and/or
(b) prices for near maturities are higher than for distant.
Backwardation occurs if convenience yield exceeds storage cost:
y − rF = y − c − rF > 0.
Crude oil forward price curves for selected dates

c Jiang Wang
3.2 Financials
For financial futures, the underlying are financial assets. Financials

have the following features:
• No cost to store (the underlying asset).
• Dividend or interest on the underlying.
1. Stock index futures.

• Underlying are bundles of stocks — S&P, Nikkei, etc.
• Futures settled in cash (no delivery).
Let the dividend yield be d, then there is the following relation
between the forward/futures price and spot price:
F = S0(1 + rF − d)T H.
Deviations from this relation triggers index arbitrage.
Example. S&P 500 closed at 1,220.75 on 2001.08.02 and

S&P futures maturing in December closed at 1,233.50. Sup-
pose the T-bill rate is 3.50%.
The annual dividend yield is: d = 0.33% (lower than historic
average).

Note:
• Since the underlying asset is a portfolio in the case of index
futures, trading in the futures market is easier than trading
in cash market.
• Thus, futures prices may react quicker to macro-economic
news than the index itself.
• Index futures are very useful to market makers, investment
bankers, stock portfolio managers:
– hedging market risk in block purchases & underwriting
– creating synthetic index fund
– portfolio insurance.

c Jiang Wang
Example. You have $1 million to invest in the stock market

and you have decided to invest in a diversified portfolio. S&P
seems a good candidate. How would you do this?
(a) One approach is to buy S&P in the cash market:
• buy the 500 stocks
• weights proportional to their market capitalization.
(b) Another way is to buy S&P futures:
• Put the money in your margin account
• Assuming S&P is at 1000 now, number of contract to
buy:
1000000
= 4.
(250)(1000)
(Value of a futures contract is $250 times the S&P
index.)
As the S&P index fluctuates, the future value of your portfolio

(in $M) would look as follows (ignoring interest payments and
dividends):
S&P Portfolio (a) Portfolio (b)
450 0.90 0.90
500 1.00 1.00
550 1.10 1.10

2. Interest rate futures.

• Underlying assets are riskless or high grade bonds.
Forward prices are simply determined by forward interest rates.
Example. Consider a T-bond with annul coupon rate of 7%

(with semi-annual coupon payments) that is selling at par.
Suppose that the current short rate is 5%. What should be
the 6-month forward price of the T-bond?
Consider the following strategy and its cash flow
Time 0 1 2 3 ···
Buy T-bond -100.0 3.5 3.5 3.5 · · ·
Sell T-bill 100.0 -102.5 0 0 ···
Net 0 - 99.0 3.5 3.5 · · ·
This strategy allows one to lock in a purchase of the 7% T-
bond 6-month later for $99. No arbitrage requires the current
forward price to be $99.
In general, a bond’s forward price is
F = S(1 + r − y)
where
• S is its spot price
• r is the spot interest rate
• y = C/S is its coupon yield.

c Jiang Wang
4 Hedging with Forwards and Futures
4.1 Hedging with Forwards
Hedging with forward contracts is simple, because one can tailor

the contract to match maturity and size of position to be hedged.
Example. Suppose that you, the manager of an oil exploration

firm, have just struck oil. You expect that in 5 months time you
will have 1 million barrels of oil. You are unsure of the future
price of oil and would like to hedge your position.
Using forward contracts, you could hedge your position by selling

forward 1 million barrels of oil. Let St be the spot oil price at t
(in months). Then,
Position Value in 5 months (per barrel)

Long position in oil S5
Short forward position F − S5
Net payoff F
Thus, in this case you know today exactly what you will receive 5
months from now. That is, the hedge is perfect.

4.2 Hedging with Futures
One problem with using forwards to hedge is that they are illiquid.
Thus, if after 1 month you discover that there is no oil, then

you no longer need the forward contracts. In fact, holding just
the forward contracts you are now exposed to the risk of oil-price
changes.
In this case, you would want to unwind your position by buying

these contracts. Given the illiquidity of forward contracts, this
may be difficult and expensive.
To avoid problems with illiquid forward markets, one may prefer

to use futures contracts.
Example. In the above example, you can sell 1 million barrels

worth of futures. Suppose that the size of each futures contract
is 1,000 barrels. The number of contract you want to short is
1, 000, 000
= 1, 000.
1, 000

c Jiang Wang
Example. Using interest rate futures to hedge a bond portfolio.

We have $10 million invested in government bonds and are
concerned with highly volatile interest rate over the next six
months. We decide to use the 6-month T-bond futures to protect
the value of the portfolio. We have
• Duration of the bond portfolio is 6.80 years.

2
• Current futures price is 93 32 (for face value of $100).
– The T-bond to be delivered has a yield of 8.80% and
duration is 9.20 years.
– Each contract delivers $100,000 face value of bonds.
– Futures price for the total contract is $93,062.50.
We should short the futures:
• If interest rate goes up, bond prices go down but a gain is

made on the short position of futures.
• If interest rate goes down, bond prices go up but a loss is
made on the short position of futures.
How many contracts to short? Match duration:
(# of contracts)(93, 062.50)(9.20) = (10, 000, 000)(6.80).
Thus:

10, 000, 000 6.80
(# of contracts) = = 79.42.
93, 062.50 9.20

Since futures contracts are standardized, they may not perfectly

match your hedging need. The following mismatches may arise
when hedging with futures:
• Maturity mismatch
• Contract size mismatch
• Asset mismatch.
Thus, a perfect hedge is available only when
1. The maturity of futures matches that of the cash flow.
2. The contract has the same size as the position to be hedged.
3. The cash flow being hedged is linearly related to the futures.
In the event of a mismatch between the position to be hedged

and the futures contract, the hedge may not be perfect.

c Jiang Wang
Example. Continuing with the example of hedging oil 5 months

from now. Suppose that you can only buy futures contracts that
mature either 3 months from now or 6 months from now. Then,
your hedge may not be perfect. Let
• St denote spot price at t
• Ht,T denote the futures price at t with maturity T (in months).
Suppose that we use the 6-month futures to hedge. Ignoring

marking to market, we have for each barrel:
Position Value 5 months from today

Long position in oil S5
Long futures position H5,6 − H0,6

Hedged position S5 − H5,6 − H0,6
Because the futures contract matures at t = 6, after 6 months

S6 = H6,6.
But after only 5 months, the futures price does not equal the spot
price then, S5. Thus, the amount that you get then will not be
exactly H0.

4.3 Basis and Basis Risk
Definition: Basis refers to the difference between the futures price

and the spot price.
Example. On 2001.08.02, S&P index closed at 1,220.75 while the

December futures closed at 1,233.50. The basis (for December
contract) is
1233.50 − 1220.75 = 12.75.
As time passes, the basis changes.
When the underlying assets of the futures market and the cash
market are identical, the basis converges to zero on the maturity
date. Hence, using futures with matching underlying and maturity
gives a perfect hedge.

c Jiang Wang
Often one has to use instruments with basis not converging to

zero on target date.
Definition: Basis risk refers to the uncertainty in the basis of a

hedging instrument on the target date.
Basis Risk
0.03
0.02
changes in spot price, futures price and basis
0.01
−0.01
−0.02 dotted line: changes in spot price

dashed line: changes in futures price
solid line: changes in basis
−0.03
0 10 20 30 40 50 60 70 80 90
time
Basis risk arises from several reasons:
• mismatch of underlying asset
Example. An investment bank shorts index futures to hedge the risk in

underwriting a large stock issue.
• mismatch of maturity
Example. Roll over short contracts to hedge long term risks.
Basis risk leads to imperfect hedge.

4.4 Minimum Variance Hedge
Definition: The hedge ratio is the number of futures used to

hedge a unit exposure to the risk of spot price.
With basis risk, how do we choose optimal hedge ratio?
The spot price and the futures price have the regression relation:
∆St = a + b∆Ht + et
where
0 = E[et]
0 = Cov[∆Ht, et ]
Cov[∆St, ∆Ht]
b =
Var[∆Ht]
Hedge Ratio
0.03
0.02
0.01
changes in spot price
−0.01
intercept = 0
slope = 0.85
st. dev. of indep. variable = 0.01
−0.02 st. dev. of residual = 0.0025
−0.03
−0.03 −0.02 −0.01 0 0.01 0.02 0.03
changes in futures price

c Jiang Wang
Defintion: The minimum variance hedge ratio is the hedge ratio

that gives the minimum variance for the value of the hedged
position.
For an arbitrary hedge ratio h, the variance of hedged position is
Var[∆St − h∆Ht] = Var[(b−h)∆Ht + et]
= (b−h)2Var[∆Ht] + Var[et].
The variance is minimized with the hedge ratio:
Cov[∆St, ∆Ht]
h∗ = b = .
Var[∆Ht]
Hedge ratio and risk

1
0.9
0.8
0.7
0.6
risk (%)
0.5
0.4
0.3
0.2
st. dev. of futures price = 1%
st.dev. of residual = 0.25%
0.1 minivariance hedge ratio = 0.85
0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8
hedge ratio

5 Homework
Readings:
• BKM Chapters 22, 23.
• BM Chapter 27.
Assignment:
• Problem Set 4.

c Jiang Wang

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What are forwards and futures contracts?

What are forwards and futures contracts?

What is the difference between forwards and futures contracts?

What is the difference between forwards and futures contracts?

Chapter 5

Forwards and Futures

Part A Introduction to ﬁnance.

Part B Valuation of assets, given discount rates.

• Fixed income securities.

Part C Determination of discount rates.

Part D Introduction to corporate ﬁnance.

• Forward and Futures Prices

• Hedging Financial Risk Using Forwards/Futures

15.407 Lecture Notes Fall 2003

• The party with a “long position” will be the buyer of the

Features of forward contracts:

• traded over the counter (not on exchanges)

• no money changes hands until maturity

• non-trivial counter-party risk.

Example. Consider a 3-month forward contract for 1,000 tons

(b) counter-party risk.

Futures contracts are designed to address these two limitations.

Deﬁnition: A futures contract is an exchange-traded, standard-

Features of futures contracts:

• Guaranteed by the clearing house — no counter-party risk

• Gains/losses settled daily

• Margin account required as collateral to cover losses.

15.407 Lecture Notes Fall 2003

Example. Yesterday, you bought ten December live-cattle con-

• Contract size 40,000 lb.

• Agreed to buy 400,000 pounds of live cattle in December.

• Value of position yesterday:

• No money changed hands.

• Initial margin required (5%-20% of contract value).

Today, the futures price closes at $0.7435/lb, 0.20 cents lower.

(0.7435)(10)(40, 000) = $297, 400

• Standardization makes futures liquid.

• Margin and marking to market reduce default risk.

• Clearing-house guarantee reduces counter-party risk.

Forward and futures contracts are derivative securities because

• zero net supply.

15.407 Lecture Notes Fall 2003

3 Forward and Futures Prices

Answer: Forward/futures prices are linked to spot prices.

Contract Spot at t Forward Futures

Ingnoring diﬀerences between forward and futures, we have

Two ways to buy the underlying for date T :

1. Buy forward or futures contract of maturity T .

2. Buy the underlying now and store it until T .

Diﬀerence between buy-and-store from forward/futures:

a. Cost of storing (for commodities)

b. Beneﬁts from storing

By arbitrage, the costs of these two approaches must equal:

F H = (1 + rF)S0 + FV (net cost of storing).

Example. Gold quotes on 2001.08.02 are

15.407 Lecture Notes Fall 2003

Example. Gasoline quotes on 2001.08.02: spot price is

For commodity futures:

Backwardation occurs if convenience yield exceeds storage cost:

Crude oil forward price curves for selected dates