Forward and Futures Contracts

Forward Contracts Have Two Limitations:

• Illiquidity
• Counterparty risk

Definition:  A futures contractis an exchange-traded, standardized,

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)

Today, the futures price closes at $0.7435/lb, 0.20 cents lower. The 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