1. Forward contracts & uses 2. Futures contracts, markets ...p2.storage.canalblog.com/22/76/366275/81304439.pdf · 22/11/2012 Pr. Didier Folus 2 • Agreement to buy or sell an underlying

22/11/2012 Pr. Didier Folus 1

Topic 4 – Forwards and futures

1. Forward contracts & uses

2. Futures contracts, markets & uses

3. Comparing futures hedge vs forwards hedge


• Agreement to buy or sell an underlying asset at a fixed

price Ft and on a fixed date T in the future, for defined

grade, quantity & place of delivery.

• Example of a forward contract on t = March 1, 2013 :

1. Forward contracts and uses

1.1. Definition & example

Asset 1 Yellow grain field corn

Nominal amount 50,000 bushels (bu)

Forward price Ft 4.00 USD/bu

Buyer United Grain Brokers Corp.

Seller Corn Grower ltd.

Maturity date May 31, 2013

Place of delivery Saint-Louis City, MO

Commitment to pay

USD 200 000

Commitment to deliver

50 000 bu

Negotiated price

between 2 counterparts

Example of cash bids :


Ft price

St price


1.2. Basis evolution

• Basis on t = Ft St

• Considering maturity T = Jan 31, 2013 :

Nov. 7 : basist=0 = 7.62 – 7.29 = + 0.33 USD

Nov. 2 : basist=1 = 7.51 – 7.40 = + 0.11 USD

Nov. 3 : basist=2 = 7.55 – 7.58 = – 0.03 USD

…

Jan. 31 : basist=86 = 0.00 USD

prime

contango

discount

backwardation

Forward price Spot price


1.3. Using forwards for hedging

1.3.1. Commodity consumer case

• On t, the Kellog’s Co. needs 50,000 bushels of corn, deliverable on T = t + 3 months :

– spot price………………… St = 3.60 USD/bu

– 3 month-forward price…... Ft = 4.00 USD/bu

• Solution 1 :

– buying spot on t

– storage

• Solution 2 :

– buying spot on T

Not risky / carrying cost

Not costly / risky

Solution 3 : buying forward on t for delivery on T :

deposit 3 % on t.…… USD 6 000

settling on T………… USD 200 000 deposit

receiving on T……… 50,000 bu of corn


ST price increase

price decrease

« l

oss

»

« p

rofi

t »

Ft = 4.00 USD/bu

Effective hedging

Cost of hedging

Forward long position

at maturity :


1.3.2. Commodity producer case

• On t, a farmer expects a 50,000 bushels corn-crop, deliverable on T = t + 3 months :

– spot price………………… St = 3.60 USD/bu

– 3 month-forward price…… Ft = 4.00 USD/bu

• Solution 1 : selling spot on T

• Solution 2 : selling forward on t for delivery on T

deposit 5 % on t.………… USD 10 000

delivering on T………….. 50,000 bu of corn

receiving on T…………… USD 200 000 + deposit


gearing

1.4. Using forwards for speculation

• Speculator, owning USD 200 000, expecting a future corn price increase

• Decision on t : buying forward 50,000 bu of corn at a price of Ft = 4.00 USD/bu, settling on T :

deposit on t.……………………….. USD 10 000

settling on T………………………. USD 200 000 deposit

receiving + selling corn on T…….. USD ST 50,000

result on T (in USD)……………… USD (ST – Ft) 50,000

return on T (in %).……………….. (ST – Ft) 50,000 /deposit


1.5. Using forwards for arbitrage

• On t, an arbitrageur, having a limit of USD 304 000 :

borrows cash…… USD 300 000 at 5⅓ % for 90 days

buys corn spot…. 75,000 bu of corn, paying 270 000 USD

stores corn……... 75,000 bu of corn, paying 20 000 USD

sells corn forward 75,000 bu of corn

• On T, the arbitrageur :

delivers corn…… 75,000 bu

receives cash…… USD 300 000

reimburses……… USD 300 000 + 4 000 USD interests

• « Riskfree » profit on T (locked on t) : USD 6 000

• Numerous arbitrageurs make disappear the profit quickly


1.6. Forwards features

• About forward contracts :

– high nominal

– effective delivery

– non-tradable on a secundary market

– counterparty risk

• About forward markets :

– major underlying assets : currencies, interest rates, commodities...

– participants : corporations & banks trading the physical asset

– brokers

– quotes & market reports

customized instruments


Market quotes : USD in London Source : Financial Times, February, 2012.

Bid, offer, mid spot rates & forward rates are derivate from Reuters

Ft,3 months St Ft,1 month Ft,1 year

2. Futures contracts and markets

2.1. Definition and example

• Futures contract :

exchange traded

commitment to

pay/deliver an asset

for a specific time,

place, grade and

quantity.

• Futures price

appears through

trades, for each

maturity.

• Each buyer/seller

faces a margin


Corn futures quotes

22/11/2012 Pr. Didier Folus 13 USD 5.8975

USD 6.5825

USD 6.4050

http://images.google.fr/imgres?imgurl=http://www.irving.cps.k12.il.us/Images/CME%2520Group%2520logo.jpg&imgrefurl=http://www.irving.cps.k12.il.us/news.htm&usg=__ajYuYWfwXzCHxCeWjVySm2IRRdU=&h=172&w=813&sz=91&hl=fr&start=19&um=1&tbnid=Tq-UdROfmA5QSM:&tbnh=30&tbnw=144&prev=/images%3Fq%3Dcme%2Bgroup%26ndsp%3D18%26hl%3Dfr%26rlz%3D1W1ADBF_fr%26sa%3DN%26start%3D18%26um%3D1

Dec 2012 corn futures chart


Futures use forwards

http://images.google.fr/imgres?imgurl=http://www.irving.cps.k12.il.us/Images/CME%2520Group%2520logo.jpg&imgrefurl=http://www.irving.cps.k12.il.us/news.htm&usg=__ajYuYWfwXzCHxCeWjVySm2IRRdU=&h=172&w=813&sz=91&hl=fr&start=19&um=1&tbnid=Tq-UdROfmA5QSM:&tbnh=30&tbnw=144&prev=/images%3Fq%3Dcme%2Bgroup%26ndsp%3D18%26hl%3Dfr%26rlz%3D1W1ADBF_fr%26sa%3DN%26start%3D18%26um%3D1


2.3. The operation of margins

• CME corn futures (up to Sep 2013) :

– initial margin = USD 2,700 per contract

– maintenance margin = USD 2,000 per contract

• On t = Nov 7, 2012, an operator buys 10 CME SEP13-corn

futures contracts, at USD 6.60 :

– commitment to pay……… 6.60 5 000 10 = USD 330,000

– maturity…………………. # 11 months

– deposit…………………… 2,700 10 = USD 27,000

• The broker/bank opens a margin account

• The CME Clearing operates margins

Margin is a SPAN parameter

Standard Portfolio

Analysis of Risk performance


Margin account running :

Date Settle

Quote

cents/bu

Daily

result

USD

Margin

account

balance

USD

Margin

call

USD

Cumula-

tive

result

USD

Nov. 7

Nov. 8

Nov. 9

Nov. 11

Nov. 12

660.00

662.00

639.00

636.00

661.00

+ 1 000

11 500

1 500

+ 12 500

27 000

28 000

16 500

18 500

32 500

3 500

1 500

+ 1 000

10 500

12 000

+ 500

Maintenance margin :

USD 2,000 per contract

Futures contracts are

daily marked to market


2.4. The clearing house

2.4.1. Functions of the clearing house

Authorizing members

Being the counterpart of each transaction

Guaranteeing full termination of operations

Fixing the deposit

Calculating and calling margins, every day

Organizing delivery and settlement

CME Clearing

Nymex Clearing House

LCH.Clearnet Ltd.

NY Clearing Corporation

Depository Trust & Clearing Corporation

Eurex Clearing Ag.


2.4.2. Rising demand for OTC clearing

• Increasing demand for clearing operations outside the Exchange traded universe

• Ex. : freight derivatives

– strong increase in the business of shipping goods to China

– shipping rate volatility : hurricanes, oil prices…

– freight forwards : OTC traded, cash-settled

• Ex. : IRS, FX, CDS

• OTC facilities :

clearing houses

exchanges

banks

2.5. Market data from Futures Industry Assoc.



Source : FIA Mag, March 2012.


Source : FIA Mag, March 2012.

Illustrative case : SG Delta One desk crash

• 2005, 2006 : initially arbitrageur on stock indexes, JK enters into

non-authorized directional positions, using futures for

« small » amounts

• March 2007 : JK enters into a massive short position on futures,

hedging it using fictive long forwards (fictive

counterparties)

• June 2007 : the real P&L shows a latent loss of EUR 2.2 Bn, but

the fictive hedged P&L is close to zero

• Nov 2007 : Eurex warning on the SG position on futures

• Dec 2007 : JK closes the position on futures, making a

EUR 1.4 bn profit, dissimulating it through the fictive

loss on long forwards, the P&L seems to be EUR 55 M.


Control

Failure…

Control

Failure…

SG Delta One desk crash (the end)

• Jan 2008 : JK enters into a EUR 50 Bn notional long position

using futures (# 30 on DJ Eurostoxx 50, # 18 on Dax,

# 2 on FTSE 100)

• Jan 16, 2008 : « back office » asks for the counterpart id. on forwards

• Jan 18, 2008 : JK lies ; the real P&L shows a EUR 2.7 Bn loss

• Jan 19, 2008 : SGCIB discovers the fraud

• Jan 20, 2008 : SG president decides to close the position immediatly

• Jan 21, 2008 : SG begins to close, in a very bearish market

• Jan 22, 2008 : the real loss equals EUR 6.3 Bn

• Jan 23, 2008 : final net loss equals EUR 4.9 Bn,

SG Board is informed…


Efficient

Control...

Too late !

947 fictive trades

115 fictive pairs

9 intra-month reserves

Lying emails


3. Hedging when using futures vs forwards

3.1. Example of a corn grain price risk

• Corn grower on date t = November 7, 2012 :

– expected crop on July 2013………. 20 000 bu

– production cost……………………. 5.00 USD/bu

– storage cost per month…………….. 50 cents/bu

• Hedging decision on t, using futures ?

– corn futures quotes (p. 13)

– buy or sell ?

– which maturity ?

– how many contracts ?

safety & cost ?

flexibility ?

risks ?


3.2. Hedging using futures : safety & cost

• Shorting four 2013-July futures contracts :

– grower must deliver…...... bu 20,000 of corn

– CME Clearing will pay… 4 5,000 7.30 = USD 146,000

– required deposit….………. USD 4 2,700

– last trading day…………… July 14, 2013

– last delivery day…………. July 16, 2013

– CME Clearing will pay on.. July 31, 2013

• Opportunity cost :

– if ST 730 cents/bu : seller regrets hedging

– if ST 730 cents/bu : hedging avoids a loss

– margin calls cost

Same as forwards

Likely

safer as

forwards

forwards


3.3. Hedging using futures : flexibility

• If Searly July = 550 cents/bu, the grower will :

harvest the corn

deliver it to the C.H. on T, receiving USD 146,000

net revenue/bu = 730 cents

• If Searly July = 830 cents/bu, the grower could :

sell spot the harvest, receiving USD 166,000

buy 4 futures at Fearly July = 825 cents/bu (supposed futures price)

pay on T : 4 5,000 (7.30 – 8.25) = - 19 000 USD

net revenue/bu = 735 cents Possibility to exit a futures

contract before expiry date

forward contracts


3.4. Hedging using futures : basis risk

3.4.1. Anticipated delivery

• If crop is early e.g. June 2013 :

– solution 1 : storing + delivering to Clearing House

– solution 2 : selling crop spot + closing futures position

• Solution 1 :

– storing harvest during 1 month…… paying USD 10,000

– delivering harvest in July 2013…… receiving USD 146,000

– net revenue/bu…………………….. 680 cents

Same using

forward contracts


Solution 2 :

• Early June, grower faces market conditions :

– spot price Searly June = 7.50 cents/bu

– futures quote Fearly June = 7.55 cents/bu

• Grower’s operations early June (date t) :

– delivering harvest, receiving (on t) 20,000 7.50 = 150,000 USD

– clearing futures, paying (on T) 45,000(7.30–7.55) = - 5,000 USD

– revenue = (Ft - (Fearly June - Searly June))nominal = 145,000 USD

• Net revenue = 725 cents/bu (expected : 730 cents/bu)

basis

No basis risk using

forward contracts

3.4.2. Gap between delivery & futures maturity

• If the producer had to hedge an August crop ?

• In November 2012, he/she sells 2013-September contracts

• In August 2013, he/she will :

– harvest & store 1 month, then deliver in Sep to the Clearing House

– harvest & deliver on spot market + close futures position implying

a basis risk


Futures contracts are not

tailor-made instruments

forward contracts

Documents

1. Forward contracts & uses 2. Futures contracts, markets ...p2.storage.canalblog.com/22/76/366275/81304439.pdf · 22/11/2012 Pr. Didier Folus 2 • Agreement to buy or sell an underlying