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Chapter 1
Introduction to Forward
and Futures Contracts
Take-Away: Understand the differences between forward and futures contracts institutionally and in terms of the marking-to-market process.
Agenda
• What are derivatives?
• How did derivatives evolve?
• Forward contracts
• Example: Using forward contracts for hedging
• Payoff diagram for long and short forward positions
• Futures contracts
• Example: Using futures contracts for hedging
• Payoff diagram for long and short forward positions
• Other types of derivatives
What are Derivatives?
• “Textbook” definition: A derivatives contract is a contract that derives its value from one or more underlying asset prices, reference rates, or indices.
• Because future payoffs of derivatives are determined by future prices of underlying securities, we can derive relationships between the current prices of the derivative and underlying securities based on no-arbitrage arguments.
• The purpose of this book is to develop and study these relationships. We also use these relationships to analyze how derivatives can be used for hedging and speculation.
• These relationships are often independent of factors such as market participants’ risk aversion, and of some of the properties of the primitive security itself.
• Derivatives are great devices to . . .
Perform successful risk management;
Deal with most market frictions;
Take on speculative positions;
Transfer risk from those who have it to those who want it.
• But proper understanding of the risks and benefits is key to success . . .
1993: Metallgesellschaft losses on oil futures $1.3 billion,
1994: P&G losses on levered swaps ~$200 million,
1994: Orange County losses on int. rate deriv. ~$1.5 billion,
1995: Barings Brothers losses on short straddle on futures ~$1.3 billion,
1998: LTCM losses on convergence strategies ~$3.5 billion,
2006: Amaranth losses on gas futures ~$500 million,
2008: Soc. Gen. losses on equity futures ~$7 billion,
2007–2009 credit crisis: CDSs (credit default swaps) and CDOs (collateralized debt obligations).
How Did Derivatives Evolve?
• Ancient Greek philosopher, Thales, obtained the right to lease the olive oil presses at fixed prices during the harvest.
• Medieval fairs in the 1400s and 1500s involved extensive use of forward contracts on grain and other goods.
• Futures on rice traded in Osaka in the 1700s.
• Options traded in Amsterdam in the 1700s.
• Futures on grains traded in Chicago in 1848 (CBOT).
• Options on equity listed on the CBOT in the 1930s.
• Financial futures traded in Chicago by the 1970s.
Forward Contracts
• A forward contract is an agreement between two parties to buy (sell) something at a pre-specified price on a pre-specified date:
The party agreeing to buy the good in the future is said to
buy a forward, and has a
long position.
The party agreeing to sell the good in the future is said to
sell a forward, and has a
short position.
• Contract specification:
Amount and quality of good to be delivered;
• The net number of outstanding contracts is always zero:
# Long Positions − # Short Positions = 0.
• Forward contracts are...
