week 4

    Cards (58)

    • Forward contract

      A commitment to purchase at a future date a given amount of a commodity or an asset at a price agreed on today
    • Forward price

      The price fixed now for future exchange
    • Long position

      The party that has agreed to buy
    • Short position

      The party that has agreed to sell
    • Spot price

      The price for immediate delivery
    • Forward contracts

      • Customized
      • Non-standard and traded over the counter (not on exchanges)
      • No money changes hands until maturity
      • Non-trivial counterparty risk
      • Illiquidity
    • Forward contract example

      • Current price of oil is $100/barrel
      • Oil buyer needs 1,000 barrels in 6 months
      • 6-month forward contract for 1,000 barrels of oil at $110/barrel
    • Futures contract
      An exchange-traded, standardized, forward-like contract that is marked to market daily
    • Mark to market

      Settling the contract every day since day 1 by paying the price difference
    • Mark to market eliminates counterparty risk
    • Futures contracts

      • Standardized contracts (underlying, quantity, maturity)
      • Exchange traded
      • Guaranteed by the clearinghouse—no counter-party risk
      • Gains/losses settled daily (marked to market)
      • Margin required as collateral to cover losses
    • Margin
      Cash or marketable securities deposited by an investor with their broker
    • Margins minimize the possibility of a loss through a default on a contract
    • Futures contracts have zero NPV
    • If the price of the futures contract is not zero
      One party will sell it to a third party and make a profit, which will drive the new price of the contract to zero
    • Futures contract example

      • NYMEX heating-oil futures with delivery in Dec. 2007 at a price of $75 / bbl. on July 27, 2007 with 51,475 contracts traded
    • Futures contract example continued

      • Arctic Fuels buys 10 of the Dec. heating-oil futures contracts at a futures price of $75 / bbl.
      • Northern Refineries sells 10 of the Dec. heating-oil futures contracts at a futures price of $75 / bbl.
    • The next day the price of the December contract increases to $77/bbl.
      • The clearinghouse pays $2 x 10,000 = $20,000 to AF's margin account.
      • NR must pay $2 x 10,000 = $20,000 into the clearinghouse.
    • If the price then drop back to $76/bbl. on the day after

      • AF must pay $1 x 10,000 = $10,000 to the clearing house.
      • The clearinghouse will put $1x 10,000 = $10,000 into NR's margin account.
    • No counterparty risk in futures contracts
    • Futures contract example continued

      • Suppose the spot price of heating oil in Dec up to $77/bbl. Then the futures price at the end of the contract will be $77/bbl.
      • For Arctic Fuels: It gets a cumulative profit of ($77-$75)x10,000 = $20,000
      • For Northern Refineries: It suffers a cumulative loss of $20,000
    • Forward contracts vs Futures contracts

      Forward contracts: Usually closed out, private contract between 2 parties, non-standard contract, 1 specified delivery date, settled at end of contract, some credit risk
      Futures contracts: Exchange traded, standard contract, range of delivery dates, settled daily, virtually no credit risk
    • Forward/futures prices ultimately linked to future spot prices
    • B
      The contract becomes more valuable as the price of the asset rises
    • C
      The contract is worth zero if the price of the asset declines after the contract has been entered into
    • D
      The contract is worth zero if the price of the asset rises after the contract has been entered into
    • Trader enters into a short cotton futures contract

      1. Futures price is 50 cents per pound
      2. Contract is for the delivery of 50,000 pounds
    • Cotton price at the end of the contract
      • 48.20 cents per pound
      • 51.30 cents per pound
    • The trader sells for 50 cents per pound something that is worth 48.20 cents per pound. Gain = ($0.5 - $0.482)x50,000 = $900
    • The trader sells for 50 cents per pound something that is worth 51.30 cents per pound. Loss = ($0.513-$0.5)x50,000=$650
    • Forward/futures prices

      Ultimately linked to future spot prices
    • Two ways to buy the underlying asset for date-T delivery

      • Buy a forward or futures contract with maturity date T
      • Buy the underlying asset now and store it until T
    • Difference between the two methods

      • Costs (storage for commodities, not financials)
      • Benefits (convenience for commodities, dividends for financials)
    • By no arbitrage, these two methods must cost the same
    • Easy to store (negligible costs of storage)
      No dividends or benefits
    • No-arbitrage requires that the forward price of gold equals the spot price of gold compounded at the risk-free rate
    • Arbitrage profit is $30 if the spot price of gold is $1,400, the 1-year forward price of gold is $1,500, and the 1-year US$ interest rate is 5% per annum
    • Arbitrage profit is $70 if the spot price of gold is $1,400, the 1-year forward price of gold is $1,400, and the 1-year US$ interest rate is 5% per annum
    • Forward price of gold
      F = S (1+r )T, where S is the spot price, r is the 1-year risk-free rate, and T is the time to maturity
    • Storage costs

      Costs of holding commodities in storage
    See similar decks