Basic differences between forward and futures …



Basic differences between forward and futures contracts

|No. |Features |Forward |Futures |

|1. |Trading |Traded by telephone or telex |Competitive arena |

|2. |Regulation |Self regulating @ OTC |Exchange traded (ETC), example : Commodity Futures |

| | | |Trading Commission |

|3. |Frequency of delivery |More than 90% of all forward contracts are settled by |Trading are settled by delivery |

| | |actual delivery | |

|4. |Size of contract |Are individually tailored and tend to be much larger |Standardized in terms of currency amount |

| | |than the standardized contracts on the futures market | |

|5. |Delivery date |Delivery any date |Only a few specified dates a year |

|6. |Settlement |Occurs on the date agreed on between the bank and the |Made daily via the Exchange Clearing house; gains on |

| | |customer |position values may be withdrawn and losses are |

| | | |collected daily or this practice is known as marking to|

| | | |market. |

|7. |Quotes |Basically quoted in European terms ( units of local |Quoted in American terms |

| | |currency per US dollar) |(dollars per one foreign currency unit) |

|8. |Transaction costs |Costs is based on bid and ask spread |Futures contracts entail brokerage fees for buy and |

| | | |sell orders |

|9. |Margins |Not required |Required to all participants in the futures market |

|10. |Credit risk |The credit risk is borne by each party to a forward |The Exchange’s Clearing House becomes the opposite side|

| | |contract. Credit limits must therefore be set for each |to each futures contract, thereby reducing credit risk |

| | |customer |substantially. |

Example 1 :

1. Marking to market : profit and losses of futures contracts are paid over every day at the end of trading.

2. on Tuesday morning, an investor takes a long position in a Swiss franc futures contract that matures on Thursday afternoon.

3. the agreed price is $0.75 for SFr 125,000.

4. Begin – investor put deposit

5. At the close of trading on Tuesday, the futures price has risen to $0.755. because of daily settlement ( M2M), three things occur. (1) : investor receive cash profit of $625, (2) : existing futures price of $0.75 is cancelled, and (3) : investor receive new futures price of $0.755.

6. at Wednesday close – price declined to $0.743. investor must pay the $1,500 loss

|Time |Action |Cash Flow |

|Tuesday morning |Investor buys futures contracts that mature in two |None |

| |days. Price is $0.75 | |

|Tuesday close |Futures prices rise to $0.755. position is marked to |Investor receives: |

| |market |125,000 X (0.755 – 0.75) = $625 |

|Wednesday close |Futures price drops to $0.743. |Investor pays: |

| |Position is marked to market |125,000 X (0.755 – 0.743) = $1,500 |

|Thursday close |Futures price drops to $0.74. | |

| |(1) Position is marked to market |(1) investor pays: |

| |(2) Investor takes delivery of SFr |125,000 X (0.743 – 0.74) =$375 |

| |125,000 | |

| | |(2) investor pays: |

| | |125,000 X 0.74 = $92,500 |

| | | |

| | |So , net loss on the futures contract = $ 1,250 |

| | | |

| | |$1,250 ($625-$1,500-$375) |

| | | |

| | |(125,000 X $0.75 = $93,750) |

| | |(125,000 X $0.74 = $92,500) |

* SFr125,000 is no. of contract size for Swiss franc

Example 2:

On Monday morning, an investor takes a long position in a pound futures contract that matures on Wednesday afternoon. The agreed upon price is $1.78 for £62,500. At the close of trading on Monday, the futures price has risen to $1.79. At Tuesday close, the price rises further to $1.80. At Wednesday close, the price falls to $1.785 and the contract matures. The investor takes delivery of the pounds at the prevailing price of $1.785. What will be the investor’s profit (loss)?

Answer

|Time |Action |Cash Flow |

|Monday morning |Investor buys pound futures contract that matures in |None |

| |two days. Price is $1.78 | |

|Monday close |Futures price rises to $1.79. Marked to market |Investor receives : |

| |contract. |62,500 X ($1.79 - $1.78) = $625 |

|Tuesday close |Futures price rises to $1.80. marked to market |Investor receives : |

| |contract |62,500 X ($1.80 - $1.79) = $625 |

|Wednesday close |Futures price falls to $1.785. |Investor pays : |

| |(1) Contract is marked to market. |(1) 62,500 X ($1.80 - $1.785) = |

| |marked to market contract |$937.50 |

| | | |

| |(2) Investor takes delivery of |(2) 62,500 X $1.785 = |

| |£62,500 |$111,562.50 |

| |

|So net profit is $625 + $625 - $937.50 = $312.50 |

Example 3:

A jobber who trades in EUR/USD has executed the following trades:

|Transaction |Amount |Currency |Rate |

|Sold |3,000,000 |EUR/USD |1.3370 |

|Sold |5,000,000 |EUR/USD |1.3350 |

|Purchased |4,000,000 |EUR/USD |1.3390 |

|Purchased |4,000,000 |EUR/USD |1.3400 |

The daily loss dealing limit assigned to the jobber is MYR50,000 per day. The revaluation rate for USD/MYR is 3.500

a. From the above trades, determine the loss suffered by the jobber in MYR

b. Determine whether the jobber is complying with the daily loss dealing limit. Explain your answer by showing your workings.

Answer

a. From the above trades, determine the loss suffered by the jobber in MYR

|EUR |Rate |USD |

|- 3,000,000 |1.3370 | + 4,011,000 |

|- 5,000,000 |1.3350 |+ 6,675,000 |

|+ 4,000,000 |1.3390 |- 5,356,000 |

|+ 4,000,000 |1.3400 |- 5,360,000 |

So, Job loss = USD30,000 or MYR105,000

b. Determine whether the jobber is complying with the daily loss dealing limit. Explain your answer by showing your workings.

No, because (USD30,000 x 3.5000 ) – MYR50,000 = MYR55,000.

The exceed daily loss dealing limit by MYR55,000 for jobber

Example 4

Suppose that the forward ask price for March 20 on Euros is $0.9127 at the same time that the price of CME euro futures for delivery on March 20 is $0.9145. How could an arbitrageur profit from this situation? What will be the arbitrageur’s profit per futures contract (contract size is 125,000).

Answer

Since the futures price exceeds the forward rate, the arbitrageur should sell futures contracts at $0.9145 and buy euro forward in the same amount at $0.9127. The arbitrageur will earn 125,000(0.9145 - 0.9127) = $225 per euro futures contract arbitraged.

Options

Definition 1 : Investopedia

A contract that grants the holder the right, but not the obligation to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

Further explanation :

Investor can hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.80 to 0.90

(meaning that it will become more expensive for a European investor to buy US dollars.) in this case, the investor would want to buy a call option on USD/EUR so that he/she could stand to gain from an increase in the exchange rate ( or the USD rise).

Notes

1. put option – give the right to sell

2. call option – right to buy

3. profit – minus premium

4. loss in option – add premium

5. in the money (ITM) – profitable to exercise at the current spot exchange rate

6. out of money (OTM) – not profitable to exercise at the current spot exchange rate

7. at the money (ATM) – exercise price = spot exchange rate

8. American options can be exercised at any time during their life

9. European options can only be exercised at maturity.

10. options traded ( EX ) at the Philadelphia Stock Exchange ; currency futures : Chicago Mercantile Exchange & Philadelphia Board of Trade.

Rules:

|If exercise price/strike price < spot price |Profit for call option |

|( X < S ) | |

| |Loss for put option |

|If exercise price > spot price |Profit – put option |

|( X > S) | |

| |Loss – call option |

Types of options

|Bil |Types |Scenario |Formula |

|1. |Buyer of a call |Limited loss |Profit = S – ( X + P ) |

| | |Unlimited profit | |

|2. |Writer/seller of a call |Limited profit |Profit = P – (S – X) |

| | |Unlimited loss | |

|3. |Buyer of a put |Limited loss |Profit = X – ( S + P) |

| | |Unlimited profit | |

|4. |Writer/seller of a put |Limited profit |Profit = P – (X – S) |

| | |Unlimited loss | |

* S – spot price; X – exercise/ strike price; P – premium

Contingency Graphs for Currency Options

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Question 1

Citigroup sells a call option on euros (contract size is €500,000) at a premium of $0.04 per euro. If the exercise price is $0.91 and the spot price of the euro at date of expiration is $0.93, what is Citigroup’s profit and loss on the call option?

Answer:

- Seller of call option , X < S – profit for call option

- Profit = P – (S – X)

- Since the spot price of $0.93 exceeds the exercise price of $0.91, Citigroup’s counterparty will EXERCISE its CALL OPTION.

- Profit = 0.04 – ($0.93 - $0.91) ………………= $0.02 per euro.

- Total gain = $0.02 X €500,000 = $10,000

Question 2

Suppose you buy three June PHLX euro call options with a 90 strike price at a price of 2.3(¢/€). (Contract size is €62,500.)

a. What would be your total dollar cost for these calls, ignoring broker fees?

Answer:

- three call option combined for €187,500 ( €62,500 X 3)

- At price of 2.3 ¢/€, the total cost is $0.023 X 187,500 = $4,312.50

b. After holding these calls for 60 days, you sell them for 3.8 ¢/€. What is your net profit on the contract, assuming that brokerage fees on both entry and exit were $10 per contract and opportunity cost was 8% p.a on the money tied up in the premium?

Answer:

- The net profit would be 1.5 ¢/€ (3.8 -2.3) .so total profit before expenses :

▪ $2,812.50 (0.015 X 187,500)

- Brokerage fees* is $10 per contract or $30 overall

- Opportunity cost : $4,312.50 X 0.08 X 60/360 = $57.50

- After deducts expenses: $87.50, the net profit is $ 2,725. ($2,812.50 - $87.50)

Notes :

Brokerage fees: is a fee charged by an agent/agent company to facilitate transactions between buyers and sellers. The brokerage fee is charged for services such as negotiations, sales, purchases, delivery or advice on the transaction. Example ‘bf’ applies in areas such as insurance, delivery services or stocks. Usually based on percentage of transaction or flat rate

Question 3

On December 6, 2004, a British pound call option with a strike price of ‘194’ was quoted for 1.15 ¢/£. The contract size for British pound is £31,250. Given the following information:

a. What is the cost of option on spot date?

b. If the buyer had chosen to exercise the option, what is the cost of purchasing the option?

c. What is the option premium?

Answer:

On December 6, 2004, a British pound call option with a strike price of ‘194’ was quoted for 1.15 ¢/£. Because the strike price is expressed in cents per pound, we can convert it to dollars per pound, or $1.94/£ and similar transformation of the option price gives $0.0115/£. For a contract size of £31,250, this option would have cost:

a. ($0.0115/£) X £31,250 = $359.38

If the buyer had chosen to exercise the option, the cost of purchasing the £31,250 would have been the strike price multiple by the contract amount or

b. ($1.94/£) X £31,250 = $ 60,625

Notice that the option premium (the cost of option) represents less than 1% of the value of the underlying purchase: P = S/X * 100%

c. $359.38 X 100 = 0.59%

$60,625

Questions should be submitted on next week on Tuesday (9 February 2010)

Futures

1. If you sold a Swiss Fran futures contract at time t and the exchange rate has evolved as shown

here, what would your cash flows have been? (Assume initial margin is $2000)

|Day |Futures price $/CHF |Change in futures |Gain or loss |Cumulative Gain or |Margin Account |

| | |price | |Loss | |

|t |0.7335 | | | | |

|t + 1 |0.7391 | | | | |

|t + 2 |0.7388 | | | | |

|t + 3 |0.7352 | | | | |

|t + 4 |0.7297 | | | | |

2. Suppose that Dell buys a Swiss franc futures contract (contract size is SFr 125,000) at a price of

$0.83. If the spot rate for the Swiss franc at the date of settlement is SFr 1 = $0.8250, what is Dell’s gain or loss on this contract?

3. On Monday morning, an investor takes a short position in a euro futures contract that matures on Wednesday afternoon. The agreed-upon price is $0.9370 for €125,000. At the close of trading on Monday, the futures price has fallen to $0.9315. At Tuesday close, the price falls further to $0.9291. At Wednesday close, the price rises to $0.9420, and the contract matures. The investor delivers the euros at the prevailing price of $0.8420. What will be the investor's profit (loss)?

Options

1. Consider a Japanese yen put option contract with strike price of 9,800 and maturity of December, which costs 0.79 US cents per 100 yen. Assume the contract size for Japan is ¥12,500,000. What is the amount to buyer of the contract should pay to seller when they are deals.

2. An investor buys a December sterling call option which is selling for a premium of 2.00 ¢/£ on a exercise price of US$1.65. The investor has bought the right to purchase one contract of a fixed size, assumed it to be £12,500, anytime between now and December. What is (a.) the effective cost of option, (b) what is the premium option, (c) what happened if the investor exercised the option?

3. Tom is a currency speculator for Madera Capital of Los Angeles. His latest speculation position is

to profit from his expectation that the US dollar will rise significantly against the Japanese Yen. The current spot rate is ¥120/$. He must choose between the following 90 day options on the Japanese Yen:

|Option |Strike price |Premium |

|Put on yen |¥125/$ |$0.00003/¥ |

|Call on yen |¥125/$ |$0.00046/¥ |

Should Tom buy a put on yen or call on yen?

Knowledge

1. What are ‘derivative instruments’? [2]

2. Explain the major differences between exchange traded derivatives transactions and over the

counter derivatives transactions. ( Use the point below)

|Features |Exchange traded |Over the counter traded |

|Amount | | |

|Delivery | | |

|Currency | | |

|Price fluctuation | | |

|Credit risk | | |

|Counterparty | | |

|Financial requirement | | |

|Cost/ earnings | | |

|Commission | | |

|Trading day | | |

|Market place | | |

-----------------------

+$.02

+$.04

- $.02

- $.04

0

$1.46

$1.50

$1.54

Net Profit per Unit

Future Spot Rate

For Buyer of £ Call Option

Strike price = $1.50

Premium = $ .02

+$.02

+$.04

- $.02

- $.04

0

$1.46

$1.50

$1.54

Net Profit per Unit

Future Spot Rate

For Seller of £ Call Option

Strike price = $1.50

Premium = $ .02

+$.02

+$.04

- $.02

- $.04

0

$1.46

$1.50

$1.54

Net Profit per Unit

Future Spot Rate

For Buyer of £ Put Option

Strike price = $1.50

Premium = $ .03

+$.02

+$.04

- $.02

- $.04

0

$1.46

$1.50

$1.54

Net Profit per Unit

Future Spot Rate

For Seller of £ Put Option

Strike price = $1.50

Premium = $ .03

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