Forward and Futures

Futures and Forwards

Futures contract are standardized legal agreement to buy or sell an asset or underlying security at a specified price at a specified time. The agreement is set up and the futures exchange intermediates between parties generally not known to each other. The underlying asset is typically a commodity or can be based on another financial instrument. The pre-agreed price is frequently referred to as the delivery price and likewise the pre-agreed date is commonly known as the delivery date. For some intuition explaining the basic rationale of the Futures market please take a look at the video clips below.

The London Metals Exchange

The London Metals Exchange (LME) is an example of a smaller but niche global player in the trading of Futures and Options on Metals (excluding precious metals). LME offers contracts with daily expiry dates of up to three months from trade date, weekly contracts to six months, and monthly contracts up to 123 months. The LME quote futures and options contracts on aluminium, aluminium alloy, cobalt, copper, lead, molybdenum, nickel, steel billet, steel rebar, steel scrap, tin and zinc.

Futures vs Forwards

Futures contracts are negotiated at futures exchanges. For a little bit of background on Futures Markets - Robert Shiller is an authoritative source both as an academic and practitioner. (A Nobel laureate and key architect of the Case-Shiller House price index which trades as a Futures). The buyer of a the underlying is said to have long position holder. The selling party correspondingly holds the short position holder. The risk of default is generally controlled by ensuring that counter-parties contribute funds into a margin account which typically is marked to mark in real time. In the absence of marking to market futures traders run the risk that their counter-party walking away if the price moves against them. By pledging collateral, traders retain skin in the game and are not incentivised to opt out when profitable to do so. This approach allows exchanges to operate somewhat more seamlessly and obviates the need to introduce rolling costly legal remedies to pursue money owing.

Forward contracts differ from Futures in that the former trade off exchange or Over-the-Counter (OTC). The Futures however is typically highly standardised. This allows price comparisons to be made though time and across markets. Forward contracts have less regimented delivery dates and less standardization and this boutique approach has help fueled the growth of OTC markets. Standardization historically was a crucial step. The development of a grading system that allowed acted as a catalyst for interoperability. Krozner (1999) points out that just as a system of weights and fineness was necessary for the use of precious metals as money, a system of grading of commodities was necessary to permit the interchangeability of the contracts - so too were was standard grade for Agricultural Commodities in the Chicago Board of Trade. The warehouse receipts common in the mid 19th century could then refer to a certain quantity of a particular grade of a commodity, for example, one hundred bushels of Chicago No.2 spring wheat, and so could the futures contract. The prototypical Futures market would appear to have a number of key aspects. See also the very elaborate measures taken to develop grading at the Cork Butter Exchange in the century preceding the setting setting up of the CBOT. Note the parallels in terms of warehousing and transport logistics that were important for any organised market operate where trading commodities.

(1) Standardization and Grading (see Telser and Higinbotham (1977))

(2) A physical infrastructure for storage, clearing and transferring the underlying.

(3) Margin accounts and collateral management.

Gains and Losses from holding Forward and Futures Positions

In the playlist below, we describe the gains and losses that arise from holding forward and futures and link this to a discussion related to Call and Put Option payoff charts. Forward and Futures contracts are distinct but there payoffs are the same if we ignore some timing differences. A convenient way to envisage what happens with forward/futures/option strategies is to examine the impact of changes in the underlying. As the value of the underlying asset changes, a profit and loss diagram, known as a “payoff chart” can be traced out. The Payoff Chart is a graphical representation of the potential outcomes of any strategy. Results may be depicted at any point in time, although the graph usually depicts the results at expiration of the forward/futures/options involved in that same strategy. We also describe what differences exist between forward and futures.

Exploring more deeply the relationship between Futures and Option positions

Below we explain how to synthetically create puts and calls using varying combinations of Futures and other option positions. To estimate premium we use Black Scholes (1973). It is worth noting that payoff charts allows us to observe the important inter-relatedness of each derivative position. Futures/Forwards and Option positions must observe parity relationships because combinations of calls and forwards can be engineered to back out put positions. These parity relationships can be re-engineered to produce a call or put or forward/futures synthetically. Merchants/traders have probably known about these linkages for many years. De la Vega is documented to have had a thorough grasp of put-call parity as early as 1688 although conventionally we attribute the mathematical underpinnings to Stoll (1969).

The no arbitrage relationship between Futures and Spot

One of the core pillars of finance embeds the principle of No Arbitrage. This would maintain that there exists no opportunities for arbitrage because all assets which will yield identical cash flows must have the same price today. This simplifies our analysis of futures prices relative to their respective spot prices. We would expect that in a well functioning market no one can easily make risk free profits where all the parties are equally informed and are numerous and have access to capital markets.