ASSIGMENT: GROUP NUMBER ONE

• ZANZIBAR UNIVERSITY
FACULTY: ARTS AND SOCIAL SCIENCES
COURSE: EFA 603:ASSET MANAGEMENT
AND DERIVATIVES
TOPIC: FUTURE CONTRACT
DATE SUBMISSION: 19/12/2016

GROUP MEMBERS: 1. ZUWENA SAID SOUD

2. ALI ADEL JUMA
3. RAMLA KHAMIS SALEH

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 Outline

• FUTURES MARKETS: OVERVIEW

• COMPONENTS OF FUTURES MARKETS

• THE
VALUATION OF FUTURES
CONTRACTS

• HEDGING CONCEPTS

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 FUTURES MARKETS: OVERVIEW

• Futures markets allow for the transfer of risk from hedgers (risk-
averse individuals) to speculators (risk-seeking individuals)

• A future contract is a standardized legal agreement between a

buyer and a seller, who promise to exchange a specified amount of
money for goods or services at a future time.

• To guarantee fulfillment of this obligation, a “good-faith” deposit,

also called margin, may be required from the buyer (and the
seller, if he or she does not already own the product).

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 FUTURES MARKETS: OVERVIEW
• Accordingly, futures contracts can be classified into three main types.
• (1) Commodity futures
• (2) Financial futures
• (3) Index futures

• commodity futures for purposes of clarity and classification its meaning here is
restricted to a limited segment of the total futures markets.
• E.g., for the sale or purchase of commodities like gold, canola, oil, pork bellies.
• Financial futures are a trading medium initiated with the introduction of contracts on
foreign currencies at the International Monetary Market (IMM) in 1972.
• E.g., for the sale or purchase of financial instruments such as currencies, stock
indices, bonds.
• An index-futures contract is one for which the underlying asset is actually a portfolio
of assets.
• E.g., stock, bond, currencies etc.

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 FUTURES MARKETS: OVERVIEW
• Futures-market participants are divided into two
broad classes: hedgers and speculators.
• Hedging refers to a futures-market transaction
made as a temporary substitute for a cash-
market transaction to be made at a later date.
• Futures market speculation involves taking a
short or long futures position solely to profit
from price changes.

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 COMPONENTS OF FUTURES
MARKETS
• The components of future markets includes:
• Exchanges
• Clearinghouse
• Margin

• Order execution
• T-bill futures transactions

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 The Exchanges
• A futures exchange, just like a stock exchange, is the stadium
for the actual daily trade. Members include individual traders,
brokerage firms, and other types of institutions. The exchange’s
governing rules and procedures are determined by its members,
who serve on various policy committees and elect the officers
of the exchanging of futures contracts.

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 The Clearinghouse
• Central to the operation of organized futures markets is the
clearinghouse or clearing corporation for the exchange. Whenever
someone enters a position in a futures contract on the long or short
side, the clearinghouse always takes the opposite side of the
contract.
• The advantages of having a central organization providing this role
are threefold.
• (1) The clearinghouse eliminates concern over the
creditworthiness of the party on the other side of the transaction.
• (2) It frees the original trading partners from the obligation of
delivery or offset with each other.
• (3) It provides greater flexibility in opening or closing a position.

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 Margin
• Whenever someone enters into a contract position in the futures
market, a security deposit, commonly called a margin
requirement, must be paid.
• marking to market –adjustments where every futures-trading
account is incremented or reduced by the corresponding
increase or decrease in the value of all open futures positions at
the end of each trading day.
• maintenance margin- the additional sum that a clearing
member firm will usually require to be deposited at the
initiation of any futures position

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 Order Execution
• Each order to buy and sell futures contracts comes to
the exchange floor either by telephone or by a
computerized order-entry system. The person
receiving the order is called a phone clerk. The phone
clerk then hands the order to a runner, who relays it to
the appropriate trading area or pit, to the floor broker.
• When the order is executed, the floor broker endorses
its time, price, and size while a specially trained
employee of the exchange, the pit observer, records
the price for immediate entry into the exchange’s
computerized price-reporting system.

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 THE VALUATION OF FUTURES CONTRACTS
• The discussions of each of the three
classifications of futures contracts have pointed
out pricing features and have examined specific
pricing models for particular types of contracts.
Nevertheless, the underlying tenets of any
particular pricing model have their roots in a
more general theoretical framework of
valuation.

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 The Arbitrage Argument
• An instant before the futures contract matures, its price
must be equal to the spot (cash) price of the underlying
commodity, or:

• = the price of the futures contract at time t, which

matures at time T,
• where T > t and T – t is a very small interval of time

• = the spot price of the underlying commodity at time t.

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 The Arbitrage Argument
• If an instant before maturity < , one could realize a sure profit
(an arbitrage profit) by simultaneously buying the futures
contract (which is undervalued) and selling the spot commodity
(which is overvalued). The arbitrage profit would equal:
• -

• However, if > is the market condition an instant before

maturity, smart traders would recognize this arbitrage condition
and sell futures contracts and buy the spot commodity until t =
T and = .
• Thus, the arbitrage process would alleviate any such pricing
disequilibrium between the futures contract and its underlying
spot commodity.

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 Interest Costs
• Futures prices should account for the interest
cost of holding the spot commodity over time,
and consequently Equation can be modified to:
• = (1+)

• = risk-free opportunity cost or interest income

that is lost by tying up funds in the spot
commodity over the interval T − t.

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 Sample Problem 1.
• On September 1, the spot price of a commodity
is $100. The current risk-free rate is 12% .
What is the value on September 1 of a futures
contract that matures on October 1 with a price
of $100?

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 Sample Problem 1. Solution
•= (1+)
• =$100

• =$101
FSept. 1. Oct. 1
• Sincethe investment is for one month only, the
annualized rate of 12% must be converted to a
monthly rate of 1%; this is done for by
dividing the annual rate by 12.

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 Carrying Costs
•In the past, someone who purchased the spot
commodity to hold from time t to a later period T,
incurs the costs of actually housing the commodity and
insuring it in case of fire or theft. The holder of a
futures contract avoids these costs borne by the spot
holder, making the value of the contract relative to the
spot commodity increase by the amount of these
carrying costs.
• (1+ ) +
• the carrying costs associated with the spot commodity
for the interval T −t.

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 Sample Problem 2.
• Extending the problem in Sample Problem 1, if the
carrying cost is $0.04 per dollar of value per month,
what is the value of the futures contract on September
1?
• (1+ ) +

• = $100+ $100($0.04/month)(1 month)

• =$105
FSept. 1. Oct. 1

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 Supply and Demand Effects
• =
• is the spot price at a future point T expected at time t,
where t < T. The tilde above indicates that the future
spot price is a random variable because future factors
such as supply cannot presently be known with
certainty.
• This is called the unbiased-expectations hypothesis
because it postulates that the current price of a futures
contract maturing at time T represents the market’s
expectation of the future spot price at time T.

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 Supply and Demand Effects
• themarket price of the futures contract will take
on the minimum value of either of these two
pricing relationship, or:
• =Min [, 1+) +]

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 Sample Problem 3
• Continuing Sample Problems 1 and 2, suppose
that the consensus expectation is that the price
of the commodity at time T will be $103. What
is the price that anyone would pay for a futures
contract on September 1?

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 Sample Problem 3. Solution

• =Min[, 1+) +]
• = Min($103, $105)

F • = $103
Sept. 1. Oct. 1

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 Sample Problem 3. continued
• The amount by which the futures price exceeds the
spot price (- ) is called the premium.
• In most cases this premium is equal to the sum of
financial costs and carrying costs . The condition of
> is associated with a commodity market called a
normal carrying-change market.
• The difference between the futures price and spot
price is called the basis.
• Basis =

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 The Effect of Hedging Demand
• The risk premium paid to the speculators for
holding the long futures position and bearing
the price risk of the hedger can be formulated
as
•= -

• is the expected risk premium paid to the

speculator for bearing the hedger’s price risk.
Keynes described this pricing phenomenon as
normal backwardation

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 The Effect of Hedging Demand
• When the opposite conditions exist — hedgers are concentrated
on the long side of the market and bid up the futures spot
pricing over the expected future spot — the pricing
relationship is called contango (I.e. ＝ - ).

• To reflect the effect of normal backwardation or contango on

the current futures price, the term in Equation (14.8) must be
adjusted for the effects of hedging demand:
• = Min[ + (1+ ) +]

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 FUTURES PRICES AND FUTURE SPOT PRICES
• CERTAINTY
• futures price forecasts have no certainty because if so
the purchase price would equal the spot the purchase
price would not change as delivery reached
• no margin would be needed to protect against
unexpected adverse price movements

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 Continued
• UNCERTAINTY
• How are futures prices related to expected spot prices?

• EXPECTATION HYPOTHESIS
• the current futures purchase price equals the consensus
expectation of the future spot price
Pf = Ps
• where Pf is the current purchase price of the futures
and
• Ps is the expected future spot price at delivery

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 Continued
• NORMAL BACKWARDATION
• KEYNES: criticized the expectation hypothesis and
stated that
• hedgers will want to be short futures
• this entices speculators to go long in the futures
markets
• to do this hedgers make the expected return from a
long position greater that the risk free rate

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 Continued
• NORMAL BACKWARDATION
• which can be written

• Pf < Ps

• this relationship known as normal backwardation

• which implies Pf can be expected to rise during the life
of the futures contract

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 Continued
• NORMAL CONTANGO
• a contrary hypothesis to Keynes’

• states that on balance hedgers want to go long in the

futures and entice speculators to be short in the futures
• to do this hedgers make

• Pf > Ps
• this implies that Pf can be expected to fall during its
contract life

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 The Effect of Hedging Demand
Figure 14-4 Bounds for Futures Prices

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 REFERENCE

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