Chapter 2

FORWARD AND FUTURES

CONTRACTS AND
APPLICATIONS
Outline

I. Mechanics of futures markets

II. Hedging strategies using futures
 I. Mechanics of Futures market
• Specification of a futures market
• Margins
• Closing out positions
• Delivery
• Market quotes
• Patterns of futures price
• Forward contracts
• OTC markets
 Specification of a futures contract
• Asset
• Contract size
• The time and place of delivery
 Margins
• A margin is cash or marketable securities
deposited by an investor with his or her
broker
• The balance in the margin account is adjusted
to reflect daily settlement
• Margins minimize the possibility of a loss
through a default on a contract
 Other Key Points About Futures

• They are settled daily

• Closing out a futures position involves
entering into an offsetting trade
• Most contracts are closed out before
maturity
 Delivery
• The vast majority of futures contracts do not lead to delivery.
Most of traders choose to close out their positions prior to
maturity.
• If a futures contract is not closed out before maturity, it is
usually settled by delivering the assets underlying the
contract. When there are alternatives about what is
delivered, where it is delivered, and when it is delivered, the
party with the short position chooses.
• A few contracts (for example, those on stock indices and
Eurodollars) are settled in cash
• When there is cash settlement contracts are traded until a
predetermined time. All are then declared to be closed out.
 Homework
• Summarize Business Snapshot 2.1 in page 25
 Market quotes
• Prices
• Settlement price
• Trading Volume and Open Interest: The trading volume
is the number of contracts traded in a day. It can be
contrasted with the open interest, which is the number of
contracts outstanding, that is, the number of long
positions or, equivalently, the number of short positions.
• Patterns of Futures
 Some Terminology
• Open interest: the total number of contracts
outstanding. This equals to number of long
positions or number of short positions
• Settlement price: The settlement price is the price
used for calculating daily gains and losses and
margin requirements. It is usually calculated as the
price at which the contract traded immediately
before the end of a day’s trading session.
• Volume of trading: the number of trades in 1 day
 Questions
• When a new trade is completed what
are the possible effects on the open
interest?
• Can the volume of trading in a day be
greater than the open interest?
 Patterns of futures price
• Normal market: The settlement futures prices
increase with the maturity of the contract.
• Inverted market: the settlement futures
prices decrease with the maturity of the
contract.
Convergence of Futures to Spot
(Figure 2.1, page 25)

Futures
Spot Price
Price
Spot Price Futures
Price

Time Time

(a) (b)
 Forward Contracts
• A forward contract is an OTC agreement to
buy or sell an asset at a certain time in the
future for a certain price
• There is no daily settlement (but collateral
may have to be posted). At the end of the
life of the contract one party buys the
asset for the agreed price from the other
party
 OTC markets
• Central Counterparties: are clearing houses for standard OTC
transactions that perform much the same role as exchange clearing
houses. Members of the CCP, similarly to members of an exchange
clearing house, have to provide both initial margin and daily variation
margin.
• Bilateral Clearing: two companies A and B usually enter into a master
agreement covering all their trades. This agreement usually includes an
annex, referred to as the credit support annex or CSA, requiring A or B,
or both, to provide collateral. The collateral is similar to the margin
required by exchange clearing houses or CCPs from their members.
Collateral agreements in CSAs usually require transactions to be valued
each day.
The Clearing House and Its Members
 A clearing house acts as an intermediary in futures transactions.
It guarantees the
performance of the parties to each transaction. The clearing house
has a number of members.
 Brokers who are not members themselves must channel their
business through a member and post margin with the member.
 The main task of the clearing house is to keep track of all the
transactions that take place during a day, so that it can calculate
the net position of each of its members.
 The clearing house member is required to provide to the clearing
house initial margin (sometimes referred to as clearing margin)
reflecting the total number of contracts that are being cleared.
There is no maintenance margin applicable to the clearing house
member.
Profit from a Long Forward or
Futures Position

Profit

Price of Underlying
at Maturity
Profit from a Short Forward or
Futures Position
Profit

Price of Underlying
at Maturity
 Forward Contracts vs Futures
Contracts (Table 2.3, page 40)
Forward Futures
Private contract between two parties Traded on an exchange
Not standardized Standardized
Usually one specified delivery date Range of delivery dates
Settled at end of contract Settled daily
Delivery or final settlement usual Usually closed out prior to maturity
Some credit risk Virtually no credit risk
II. Hedging strategies using futures
1. Basic principles
1.1. Short hedge
1.2.Long hedge
1.3. Basis risk
1.4. Choice of contract
2. Cross hedging
3. Stock index futures
3.1. Hedging an equity portfolio
3.2. Changing the beta of a portfolio
 Long & Short Hedges
• A long futures hedge is appropriate when
you know you will purchase an asset in the
future and want to lock in the price
• A short futures hedge is appropriate when
you know you will sell an asset in the future
& want to lock in the price
 Short Hedges- Example (a)
• It is May 15 today and an oil producer has just
negotiated a contract to sell 1 million barrels of crude
oil. It has been agreed that the price that will apply in
the contract is the market price on August 15. How
does the firm hedge its exposure?
• Suppose that on May 15, the spot price is $60 per
barrel and the crude oil futures price on the NYMEX
for August delivery is $59 per barrel. Each futures
contract on NYMEX is for the delivery of 1,000 barrels.
• Short hedge: the company can hedge its exposure by
shorting 1,000 futures contracts for August delivery
and close its position on August 15.
 Short Hedges- Example (b)
• On August 15
(1) Suppose the spot price is $55 per barrel:
 The firm realizes $55 million for the oil under its sales
contract.
 August is the delivery month for the futures contract 
The futures price on August 15 should be very close to the
spot price of $55 on that date.  The firm gains
approximately 59 - 55= $4 per barrel or $4 million in total
from the short futures position.
 Total amount realized from both the futures position and
the sales contract is approximately $59 per barrel or $59
million in total.
 Short Hedges- Example (c)
• On August 15
(2) Suppose the spot price is $65 per barrel:
 The firm realizes $65 million for the oil under its sales
contract.
 August is the delivery month for the futures contract 
The futures price on August 15 should be very close to
the spot price of $65 on that date.  The firm losses
approximately 65 - 59= $6 per barrel or $6 million in
total from the short futures position.
 Total amount realized from both the futures position and
the sales contract is approximately $59 per barrel or $59
million in total.
 Long Hedges- Example (a)
• It is now January 15. A copper fabricator
knows it will require 100,000 pounds of
copper on May 15 to meet a certain contract.
How does the firm hedge its exposure?
• Suppose that the spot price of copper is 340
cents per pound, and the futures price for
May delivery is 320 cents per pound.
• Long hedge: the firm can hedge its exposure
by taking a long position in four futures
contract on COMEX division of NYMEX and
closing its position on May 15.
 Long Hedges- Example (b)
• On May 15:
(1) Suppose the spot price is 325 cents per pound.
 The firm pays: 100,000 x$3.25= $325,000 for the
copper in the spot market.
 May is the delivery month for the futures contract 
The futures price on May 15 should be very close to
the spot price of 325 cents on that date.  The firm
gains approximately 325 - 320= 5 cents per pound or
$5000 on the futures contract.
It net cost is approximately $320,000 or 320 cents per
pound.
 Long Hedges- Example (c)
• On May 15:
(1) Suppose the spot price is 305 cents per pound.
 The firm pays: 100,000 x$3.05= $305,000 for the
copper in the spot market.
 May is the delivery month for the futures contract 
The futures price on May 15 should be very close to
the spot price of 305 cents on that date.  The firm
losses approximately 320- 305= 15 cents per pound or
$15000 on the futures contract.
It net cost is approximately $320,000 or 320 cents per
pound.
 Homework
• Read 3.2 ARGUMENTS FOR AND AGAINST HEDGING (page
51) in the textbook to discuss whether a firm should hedge
the risks or should not hedge and focus on their main
activities.
• Basis risk:
In practice, hedging is often not quite as
straightforward, because:
The asset whose price is to be hedged may not
exactly the same as the asset underlying the futures
contract.
 The hedger may be uncertain as to the exact date
when the asset will be bought or sold.
 The hedge may require the futures contract to be
closed out before its delivery month.
 Basis risk often exists.
Convergence of Futures to Spot
(Hedge initiated at time t1 and closed out at time t2)

Futures
Price

Spot
Price

Time

t1 t2
 Basis Risk
• Basis is the difference between spot &
futures:
Basis= Spot price of asset to be hedged –
Futures price of contract used
• Basis risk arises because of the uncertainty
about the basis when the hedge is closed out
 Long Hedge
• Suppose that
F1 : Initial Futures Price (time t1)
F2 : Final Futures Price (time t2)
S2 : Final Spot Price (time t2)
Basis=b2 = S2-F2
• You hedge the future purchase of an asset by
entering into a long futures contract
• Cost of Asset=S2 – (F2 – F1) = F1 + Basis
• If basis increases unexpectedly , the hedger’s
position worsen; if basis decreases unexpectedly, the
hedger’s position improves.
 Short Hedge
• Suppose that
F1 : Initial Futures Price (time t1)
F2 : Final Futures Price (time t2)
S2 : Final Spot Price (time t2)
Basis= b2= S2-F2
• You hedge the future sale of an asset by entering
into a short futures contract
• Price Realized=S2+ (F1 – F2) = F1 + Basis
• If basis increases, the hedger’s position improves
unexpectedly; if basis decreases unexpectedly,
the hedger’s position worsens.
If the asset underlying the futures contract is not
the same as the asset whose price is being
hedged:
• S2* : spot price of the underlying asset at time t2 :
• F1-F2 +S2 = F1 + (S2*-F2)+(S2-S2*)
Basis consists of two components:
S2*-F2 : the difference between spot & futures of
the underlying asset.
S2-S2* : the difference between the spot prices of the
two assets.

•
 Problems
1.On March 1 the spot price of a commodity is $20 and the July
futures price is $19. On June 1 the spot price is $24 and the
July futures price is $23.50. A company entered into a futures
contracts on March 1 to hedge the purchase of the
commodity on June 1. It closed out its position on June 1.
What is the effective price paid by the company for the
commodity?
2. On March 1 the price of a commodity is $300 and the
December futures price is $315. On November 1 the price is
$280 and the December futures price is $281. A producer
entered into a December futures contracts on March 1 to
hedge the sale of the commodity on November 1. It closed
out its position on November 1. What is the effective price
received by the producer?
 Choice of Contract (a)
• The choice of the asset underlying the futures
contract.
• The choice of the delivery month
 Choice of Contract (b)
• Choose a delivery month that is as close as
possible to, but later than, the end of the life
of the hedge
• When there is no futures contract on the asset
being hedged, choose the contract whose
futures price is most highly correlated with
the asset price.
 Choice of Contract- Example (a)
• It is March 1. A US company expects to receive 50
million Japanese yen at the end of July. Yen futures
contracts on the CME have delivery months of
March, June, September and December. One
contract is for the delivery of 12.5 million yen.
• The company shorts four September yen futures
contract on March 1. When the yen are received at
the end of July, the company closes out its position.
• The futures price on March 1 in cents per yen is
0.7800 and the spot and futures prices when the
contract is closed out are 0.72000 and 0.7250,
respectively.
 Choice of Contract- Example (b)
• The gain on the futures contract: 0.7800-0.7250 =
0.0550 cents per yen.
• The basis: 0.72000-0.7250= -0.0050.
• The effective price obtained in cents per year:
The final spot price + the gain
0.7200 + 0.0550 = 0.7750
 Or the initial future price + the final basis
0.7800 + (-0.0050) = 0.7750
Cross hedging:
• When the asset underlying the futures contract is
not the same as the asset to be hedged.
• Ex: An airline is concerned about the future price
of jet fuel. Because there is no futures contract on
jet fuel, it might choose to use heating oil futures
contracts to hedge its exposure.
• Hedge ratio: is the ratio of the size of the position
taken in futures contracts to the size of the
exposure.
• When the asset underlying the futures contract is
the same as the asset being hedged, the hedge
ratio equals 1.
• The hedger should choose a value for the hedge
ratio that minimizes the variance of the value of
the hedged position.
 Optimal Hedge Ratio
Proportion of the exposure that should optimally be
hedged is

h*   S
F
where
S is the standard deviation of S, the change in the spot
price during the hedging period,
F is the standard deviation of F, the change in the
futures price during the hedging period
 is the coefficient of correlation between S and F.
Optimal Hedge Ratio
• How to calculate h*?
- Using data on the changes in historical spot
and futures prices.
+ Choose a number of equal non-overlapping
time intervals. Ideally, the length of each
interval is the same as the length of the time
interval for which the hedge is in effect.
+ Observe the changes in spot price of the
asset being hedged and the changes in
future price of the underlying asset. 
Compute the standard deviations of these
changes.
Optimal number of contracts
- QA: Size of position being hedged (units)
- QF: Size of one futures contract (units)
- N* : Optimal number of futures contracts
for hedging.

* QA
*
N h
QF
• Ex: An airline expects to purchase 2
million gallons of jet fuel in 1 month and
decides to use heating oil futures for
hedging. The size of one heating oil
futures contract is 42,000 gallons 
Compute the optimal number of futures
contracts for hedging.
• Data on the changes in historical prices:
Month Changes in heating oil Changes in jet fuel
(i) futures price per gallon price per gallon
(xi) (yi)
1 0.021 0.029
2 0.035 0.020
3 -0.046 -0.044
4 0.001 0.008
5 0.044 0.026
6 -0.029 -0.019
7 -0.026 -0.010
8 -0.029 -0.007
9 0.048 0.043
10 -0.006 0.011
11 -0.036 -0.036
12 -0.011 -0.018
12 0.019 0.009
14 -0.027 -0.032
15 0.029 0.023
Method 1: Calculate mean, standard deviation,
correlation of the changes in the spot and
futures prices.
 F  0.0313  S  0.0263
  Cov( F , S ) /  F  S  0.928
h= 0.928x(0.0263/0.0313) = 0.78

Method 2: h* is the slope of the best-fit line

when deltaS is regressed against deltaF.
deltaS = 0.78 deltaF
• The optimal number of futures contracts
for hedging:

0.78 x 2,000,000/42,000 = 37.14

Problems
3. Suppose that the standard deviation of quarterly changes in the
prices of a commodity $0.65, the standard deviation of
quarterly changes in a futures price on the commodity is $0.81,
and the coefficient of correlation between the two changes is
0.8. What is the optimal hedge ratio for a 3-month contract?
What does it mean?
4. The standard deviation of monthly changes in the spot price of
live cattle is (in cents per pound) 1.2. The standard deviation of
monthly changes in the futures price of live cattle for the closest
contract is 1.4. The correlation between the futures price
changes and the spot price changes is 0.7. A beef producer is
committed to purchasing 200,000 pounds of live cattle next
month. The producer wants to use the live cattle futures
contracts to hedge its risk. Each contract of/ for the delivery of
40,000 pounds of cattle. What strategy should the beef
producer follow?
• Stock index futures
- A stock index tracks changes in the value of a
hypothetical portfolio of stocks.
- The weight assigned to the stocks are
proportional to their market prices or their market
capitalizations.
- Return on the stock index is usually used as a
proxy of the market return. The stock index is
given a beta of 1.
- Some exchanges provide futures contracts for
underlying assets of stock indices. For example:
Dow Jones Industrial Average, S&P500, Nasdaq
100 Index futures contracts.
 Hedging Using Index Futures

To hedge the risk in a portfolio the number

of contracts that should be shorted is
VA
N*  
VF
where VA is the current value of the
portfolio, is its beta, and VF is the current
value of one futures (=futures price times
contract size)
• Example (a) : Suppose that a futures contract with 4
months to maturity is used to hedge the value of a
portfolio over the next 3 months:
- Value of portfolio= $5,050,000
- Beta of portfolio= 1.5
- Value of S&P 500 index= 1000
- S&P 500 futures price= 1,010 USD
- Risk-free interest rate =4% per annum
- Dividend yield on index =1% per annum
- One contract is on $250 times the index
- What position in futures contracts on the S&P 500
is necessary to hedge the portfolio?
Example

• Suppose that the index turns out to be 900 in 3

months and the futures price is 902. Calculate
the value of the hedged portfolio in 3 months?
Problems
5. On July 1, an investor holds 50,000
shares of a certain stock. The market price
is $30 per share. The investor is interested
in hedging against movements in the
market over the next month and decides to
use the September Mini S&P 500 futures
contract. The index futures price is
currently 1,500 and one contract is for
delivery of $50 times the index. The beta
of the stock is 1.3. What strategy should
the investor follow?
6. A fund manager has a portfolio worth $50 million with
a beta of 0.87. The manager is concerned about the
performance of the market over the next 2 months and
plans to use 3-month futures contracts on the S&P
500 to hedge the risk. The current level of the index is
1,250, one contract is on 250 times the index, the risk-
free rate is 6% per annum, and the dividend yield on
the index is 3% per annum. The current 3-month
futures prices is 1259.
• What position should the fund manager take to hedge
all exposure to the market over the next 2 months?
• Suppose that in 2 months, the index decreases to
1000, and the index futures price is 1002.5. Calculate
the expected value of the company after hedging the
risk.
 Homework
Reasons for Hedging an Equity Portfolio
• The hedger might be very uncertain about the performance of the
market as a whole, but confident that the stocks in the portfolio
will outperform the market (after appropriate adjustments have
been made for the beta of the portfolio). A hedge using index
futures removes the risk arising from market moves and leaves
the hedger exposed only to the performance of the portfolio
relative to the market.
• Another reason for hedging may be that the hedger is planning to
hold a portfolio for a long period of time and requires short-term
protection in an uncertain market situation. The alternative
strategy of selling the portfolio and buying it back later might
involve unacceptably high transaction costs.
• Read p.66
Changing the beta of a portfolio
• Sometimes futures contracts are used to
change the beta of a portfolio to some value
other than zero.
- To reduce the beta, the number of futures
contract should be shorted:
P
N *  (   * )   *
F

- To increase the beta, the number of futures

contracts should be taken in a long position:
* * P *
N  (   )  
F
•Example
-Value of portfolio= $5,050,000
-Beta of portfolio= 1.5
-Value of S&P 500 index= 1000
-S&P 500 futures price= 1,010 USD
-One contract is on $250 times the index
 What position is necessary to reduce the beta of
the portfolio to 0.75?
 What position is necessary to increase the beta of
the portfolio to 2.0?
Problems
7. A company has a $20 million portfolio with a beta of
1.2. It would like to use futures contracts on the S&P
500 to hedge its risk. The index futures price is
currently standing at 1080, and each contract is for
delivery of $250 times the index. What is the hedge
that minimizes risk? What should the company do if it
wants to reduce the beta of the portfolio to 0.6?
Problems
8. It is July 16. A company has a portfolio of stocks
worth $100 million. The beta of the portfolio is 1.2.
The company would like to use the CME December
futures contract on the S&P 500 to change the beta
of the portfolio to 0.5, during the period July 16 to
November 16. The index futures price is currently
1,000, and each contract is on $250 times the index.
- What position should the company take?
- Suppose that the company changes its mind and
decides to increase the beta of the portfolio from 1.2
to 1.5. What position in futures contracts should it
take?
9. A fund manager has a portfolio worth $100 million. The
beta of the portfolio is 1.2. The manager is concerned about
the performance of the market over the next 2 months and
plans to use 3-month futures contracts on the S&P 500 to
hedge the risk. The current level of index is 1,250, one contract
is on 250 times the index, the risk-free rate is 6% per annum,
the dividend yield on the index is 3% per annum. The current
futures price is 1259.
a.What position should the fund manager take to hedge all
exposure to the market over the next 2 months?
b.Suppose that the index in 2 months is 1200, the 1-month
futures price is 0.25% higher than the index level at this time.
Calculate the expected value of the portfolio in 2 months after
hedging the risk.