Forward and Futures Contracts
Finance Theory
Futures Contracts
Forward Contracts Have Two Limitations:
- Illiquidity
- Counterparty risk
forward-like contract that is marked to marketdaily. This contract can
be used to establish a long (or short) position in the underlying asset.
Features of Futures Contracts
- Standardized contracts:
– Underlying commodity or asset
– 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
Example:
NYMEX crude oil (light) futures with delivery in Dec. 2007 at a price of
$75.06 / bbl. on July 27, 2007 with 51,475 contracts traded
- Each contract is for 1,000 barrels
- Tick size: $0.01 per barrel, $10 per contract
- Initial margin: $4,050
- Maintenance margin: $3,000
- No cash changes hands today (contract price is $0)
- Buyer has a "long" position (wins if prices go up)
- Seller has a "short" position (wins if prices go down)
Payoff Diagram
Example. Yesterday, you bought 10 December live-cattle contracts on the
CME, at a price of $0.7455/lb
- Contract size 40,000 lb
- Agreed to buy 40,000 pounds of live cattle in December
- Value of position yesterday: (0.7455)(10)(40,000) = $298,200
- No money changed hands
- Initial margin required (5%−20% of contract value)
of your position is
(0.7435)(10)(40,000) = $297,400
which yields a loss of $800.
Why Is This Contract Superior to a Forward Contract?
- Standardization makes futures liquid
- Margin and marking to market reduce default risk
- Clearing-house guarantee reduces counter-party risk
