Introduction to Futures and Forwards

Which assets can options apply to?

Equities, interest rates, bonds, currencies, gold and oil.

What are forwards and futures contracts?

Allow users to trade an asset today, at a price and in a quantity agreed today, but for a settlement at an agreed point in the future. Entering into a forwards contract eliminates the risk of a price rise, hence they are hedging this risk.

How does a forwards contract work?

For example, for a company making jewellery, they need platinum at a point in the future, and are concerned that the price may rise well above today’s level to a level they are unable to pay. By entering into a forward contract, they can fix the price today, to purchase the platinum in the future. All of the details are agreed upfront, and then the settlement occurs say 3 months later.

What is an example of a forwards contract transaction?

• For example: “We R Jewels” buys 1000 ounces of Platinum from “Mynah Co Ltd” for settlement in 3 months time, for $1000 per troy ounce
• At trade date, the 2 parties agree to the terms of the trade and sign contracts.  After 3 months, We–R-jewels pays $1m to Mynah CO, and Mynah Co delivers 1000 ounces of Platinum to We-R-Jewels

What is a “zero-sum game”?

Many people say that derivatives, such as the forward contract above are a “zero-sum game” - one party makes and the other loses in opposite amounts. If the platinum price rises, the jeweller makes money on the trade and the miner loses money - and they exactly offset each other - making it “zero sum”.

LMCorp stock is trading at $36 per share, and pays a dividend of $1.48 in 2 month’s time. The interest rate is 2% per annum. What would be the fair price for a 3 month forward stock on LMCorp stock?

The way to think about this is to make your own forward trade. Imagine buying LMCorp stock now and holding the position for 3 months - how much would this cost in total?

• Borrow $36 and buy 1 share of LMCorp stock
• Over 3 months, the interest on the borrowing would be 2% x 0.25 x $36 = $0.18, so you would need to pay back $36.18
• But you would earn the dividend, which would reduce the total cost by $1.48
• Giving you a total cost of $34.70 - hence this is the fair price of 3 month forward

What is the formula for calculating the fair forward price?

Spot Price + Costs of Holding - Benefits of Holding

What does the pricing of a 3 month forward NOT involve?

Does not involve any discussion, prediction or guessing of the price of LMCorp shares in 3 months time. We are using the spot-forward arbitrage to price the forward contract - where the arbitrageur would trade the spot an drudge with the forward and so be left with no exposure to the price of the underlying.