Financial

Derivative

Forward and Future

Contracts

Forward Contract
In a forward contract, the
purchaser and its counterparty are
obligated to trade a security or
other asset at a specified date in the
future .
Options ate traded on OTC

How is the exchange rate for a

Forward Contract determined?
A forward rate is calculated by looking at

the interest rate difference between the two

currencies involved.
In the forward market, the currency of a
country with lower interest rates than our
currency will trade at a "premium". The
currency of a country with higher rates than
ours will trade at a "discount".

Example
if a client is buying a 30 day US dollar
forward contract, the difference between the
spot rate and the forward rate is calculated
as follows:

Assume
The interest rate earned on US$ is less
than the interest rate earned on CAD$.

if Calforex sells $100,000USD transaction

the spot market was 1.52 and the interest rate
differential was 1%, the 30 day forward
contract rate would be calculated as follows:
$100,000USD x 1.5200 = $152,000 CAD
$152,000CAD x 1% divided by 12 months =
$126.67
$152,000CAD + $126.67 = $152,126.67CAD
$152,126.67CAD/$100,000USD = 1.5213

Therefore, in this example the forward rate

would be 12 points higher than the spot rate
on a thirty-day contract.

How The forward contract works

An example a farmer is about to plant his

summer crop of wheat, and estimates it will cost

$3.00 per bushel to grow the wheat. The farmer
expects that the crop will yield one hundred
thousand bushels at harvest time. The farmer
enters into a forward contract with a buyer of the
wheat crop who has a use for the crop, to sell the
anticipated one hundred thousand bushels of
wheat at predetermined price and date.

The Advantage/Disadvantage of A
forward Contract

Advantage
Both parties
have limited
their risk

Disadvantage
You must make or take delivery of
the commodity and settle on the
deliver date and honor the contract
as agreed upon
The buyer and seller are
dependent upon each other.
In a forward contract, any profits or
losses are not realized until the
contract "comes due" on the
predetermined date.

Future Contract
A future is a standardized derivative contract

between two parties: a buyer and a seller.

Being a standardized contract means that the
buyer and seller do not contract directly with each
other. Instead, they contract with the intermediary
known as the clearinghouse. The clearinghouse
protects their potential liability by requiring that
margin be deposited and all positions are markedto-market on at least a daily basis .

Marking-to-market
The installment method used with futures is
called marking-to-the-market.

Clearing House
Act as a third party-go-between on all buys
and sells

Margin
With a hedging strategy, must establish and
maintain a margin account (performance bond) with
broker as insurance against defaulting on any loss. .
Initial margin: Initial deposit of funds required to be
deposited.
Amount required in this account varies from broker
to broker

 Minimum margin requirements for a particular

futures contract at a particular time are set by
the exchange on which the contract is traded.
They are typically five to 10 percent of the
value of the futures contract
Margin calls may bring the value of your
margin account to original initial margin level.
Small loss allowed before margin calls.
Maintenance margin is the loss level which
initiates a margin call..

 Note that once a trader recieves a margin

call, he must meet that call, even if the price
has subsequently moved in his favor.
If no money is deposited on the day of the
margin call or early the next morning, the
commodity broker will automatically make
an offset trade to terminate the clients
futures position. Brokers will offset, in this
case, to protect the brokerage house.

 Example:Marking to the market

Buy 2 March S&P 500 Futures
@$1000 = 2*250*$1000=250000
Initial margin = 25000
Maintainance margin = 20000

Futures
Price $

Action

0 1000.00 Buy contract

Cash
Flow $

D/W
$

Account
Equity $

25000 25000

1 1005.00 Seller pays

buyer

2500

27000

2 1015.00 Seller pays

buyer

5000

1000 31500

995.00

Buyer pays
seller

-10000

21500

985.00

Buyer pays
seller

-5000

8500 25000

990.00

Seller pays
buyer

2500

27500

Contract obligation:Delivery or
Offset
A holder of a future contracts has 2 choices
of how to deal with the legal obligations
before the last trading day of the delivery
month
1. Delivering or taking delivery
2. Offset

Forward vs. Futures Contracts

Rules
Organized market place / OTC
Standardized trading
Guaranteed settlement
Margin and Daily settlement
Liquidity