Financial Derivative

Forward and Future Contracts

Forward Contract• In a forward contract, the

purchaser and its counterparty are obligated to trade a security or other asset at a specified date in the future .

• Options ate traded on OTC

How is the exchange rate for a Forward Contract determined?

• A forward rate is calculated by looking at the interest rate difference between the two currencies involved.

• In the forward market, the currency of a country with lower interest rates than our currency will trade at a "premium". The currency of a country with higher rates than ours will trade at a "discount".

Example if a client is buying a 30 day US dollar

forward contract, the difference between the spot rate and the forward rate is calculated as follows:

Assume The interest rate earned on US$ is less

than the interest rate earned on CAD$.

•if Calforex sells $100,000USD transaction the spot market was 1.52 and the interest rate differential was 1%, the 30 day forward contract rate would be calculated as follows:

$100,000USD x 1.5200 = $152,000 CAD$152,000CAD x 1% divided by 12 months = $126.67 $152,000CAD + $126.67 = $152,126.67CAD $152,126.67CAD/$100,000USD = 1.5213

Therefore, in this example the forward rate would be 12 points higher than the spot rate on a thirty-day contract.

How The forward contract works

• An example a farmer is about to plant his summer crop of wheat, and estimates it will cost $3.00 per bushel to grow the wheat. The farmer expects that the crop will yield one hundred thousand bushels at harvest time. The farmer enters into a forward contract with a buyer of the wheat crop who has a use for the crop, to sell the anticipated one hundred thousand bushels of wheat at predetermined price and date.

The Advantage/Disadvantage of A forward Contract

Advantage• Both parties

have limited their risk

Disadvantage• You must make or take delivery of

the commodity and settle on the deliver date and honor the contract as agreed upon

•  The buyer and seller are dependent upon each other.

• In a forward contract, any profits or losses are not realized until the contract "comes due" on the predetermined date.

Future Contract• A future is a standardized derivative contract

between two parties: a buyer and a seller. • Being a standardized contract means that the

buyer and seller do not contract directly with each other.  Instead, they contract with the intermediary known as the clearinghouse.  The clearinghouse protects their potential liability by requiring that margin be deposited and all positions are marked-to-market on at least a daily basis. 

Marking-to-market  • The installment method used with futures is

called “marking-to-the-market”.

Clearing House• Act as a third party-go-between on all buys

and sells

Margin• With a hedging strategy, must establish and

maintain a margin account (performance bond) with broker as insurance against defaulting on any loss. .

• Initial margin: Initial deposit of funds required to be deposited.

• Amount required in this account varies from broker to broker

   

• Minimum margin requirements for a particular futures contract at a particular time are set by the exchange on which the contract is traded. They are typically five to 10 percent of the value of the futures contract

• Margin calls may bring the value of your margin account to original initial margin level. Small loss allowed before margin calls.

• Maintenance margin is the loss level which initiates a margin call..

• Note that once a trader recieves a margin call, he must meet that call, even if the price has subsequently moved in his favor.

• If no money is deposited on the day of the margin call or early the next morning, the commodity broker will automatically make an offset trade to terminate the client’s futures position. Brokers will offset, in this case, to protect the brokerage house.

• Example:Marking to the market

Buy 2 March S&P 500 Futures @$1000 = 2*250*$1000=250000

Initial margin = 25000

Maintainance margin = 20000

D Futures

Price $

Action Cash Flow $

D/W

$

Account

Equity $

0 1000.00 Buy contract 0 25000 25000

1 1005.00 Seller pays buyer

2500 27000

2 1015.00 Seller pays buyer

5000 1000 31500

3 995.00 Buyer pays seller

-10000 21500

4 985.00 Buyer pays seller

-5000 8500 25000

5 990.00 Seller pays buyer

2500 27500

Contract obligation:Delivery or Offset

• A holder of a future contracts has 2 choices of how to deal with the legal obligations before the last trading day of the delivery month

1. Delivering or taking delivery

2. Offset

Forward vs. Futures Contracts

• Rules

• Organized market place / OTC

• Standardized trading

• Guaranteed settlement

• Margin and Daily settlement

• Liquidity