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Example of a forward contract

AFF9150 Lecture 2: Forwards and Futures
Binh Do

Futures Standardized Contract Terms Unilateral Reversal of Positions

Required reading: Sundaram and Das – Ch 1 (pp5-9) & Ch 2

Default Risk and Margin Accounts

Case Study: Metallgesellschaft AG

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What is a forward contract?

Payoff to a forward contract



A private agreement between two parties, a buyer and a seller, that calls for delivery of an asset at a future date with a price agreed upon today (“forward price”) Example: On 1/3/12, a buyer and a seller enters a forward contract on 5000 ANZ shares (the underlying) at $22 (forward) for settlement on 30/6/12 (expiration/delivery date). Price for ANZ share on 1/3/12 is $21 (spot price)



Assuming the actual price for ANZ share on 30/6/12 is $23. The buyer receives the shares and pay the seller $22/share, thus making a profit of (23-22)*5000 =$5000 If the actual price on 30/6/12 is $20 instead, the buyer still takes delivery of the shares and pay $22/share, thus incurring a loss of (22-20)*5000=10,000 The above is physical settlement: buyer takes delivery from seller and pays the forward price. Alternatively, the contract may require cash settlement: upon settlement, the losing party simply pays the other the difference. Economic outcomes are largely the same under both methods 4










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Payoff function and payoff diagram to a long forward contract

Payoff function and payoff diagram to a short forward contract

Payoff ST F0
Payoff diagram


Payoff function: ST –F0

Profit
Payoff function: F0 –ST

ST F0
Payoff diagram
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A payoff function expresses the value of a position at maturity, as a function of the underlying variable ST A payoff diagram graphs the payoff function, showing value of a position at different possible values of ST 5



Credit risk/Counterparty risk in a forward contract
• There is possibility that the party who’s sitting on a losing position fails to make payment when due: counterparty risk This risk is particularly high in over-the-counter (OTC) markets like forwards To lessen this risk, forward market is restricted to financial institutions and big corporations, who will assess the credit risk of prospective parties and only trade within credit limit Futures offer a lower counterparty risk alternative



Futures





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The Origins

The 19th Century

As economic mechanisms, forward markets are very old. Futures Industry Association traces the origin of forward trading to India around 2,000 BC. Substantial evidence of forward markets in Greco-Roman and medieval Europe. World's first futures market was quite possibly the Dojima Rice Market (Osaka, 1730).

 Modern futures markets are most associated with 19th century America, particularly the grain markets of Chicago.  The Chicago Board of Trade (CBoT) was established in 1848.  Swiftly followed by a number of other exchanges (New York, Milwaukee, St. Louis, Kansas City, ... ).  Over a thousand commodity exchanges sprang up in the US by the end of the 19th century.

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The Top 15 Futures Contracts Worldwide: 2008

Standardized Contract Terms

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Standardization

Example of quantity standard: Commodity Futures Contracts

 Contract terms must be standardized, since buyer and seller do not interact directly.  Standardization is perhaps the most important task performed by the exchange.  Essential in promoting liquidity and improving quality of hedge.  Apart from contract maturity dates, standardization involves three components: 1. Quantity (size of contract). 2. Quality (standard deliverable grade). 3. Delivery options (other deliverable grades + price adjustment mechanism).

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Example: Financial Futures Contracts

Example: "Mini" Futures Contracts

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SFE SPI 200 Index Futures

Example of the grade standard: The Corn Futures Contract

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