83

4
Forwards and Futures

4.1 Introduction EXTENSION 4.2 Futures Exchanges

in China, India, and Ethiopia, and
4.2 Forward Contracts
E-Choupal in Village India
4.3 The OTC Market for Trading
4.6 Hedging with Forwards and
Forwards
Futures
4.4 Futures Contracts
4.7 Summary
4.5 Exchange Trading of a Futures
4.8 Cases
Contract
EXTENSION 4.1 Forward and Futures 4.9 Questions and Problems
Prices: The Same or Different?
84 CHAPTER 4: FORWARDS AND FUTURES

4.1 Introduction
Surprisingly although many think of derivatives as new and sophisticated securi-
ties, this is hardly the case. Forward contracts are the oldest known derivatives,
tracing their origins back to India (2000 bc), to ancient Babylonia (1894–1595 bc),
and even to Roman merchants trading grains with Egypt.1 Futures contracts are
“the new kids on the block.” The oldest futures contracts traded in Amsterdam,
Netherlands, in the middle of the sixteenth century and on the first futures ex-
change, the Dojima Rice Exchange in Osaka, Japan, in 1688. As such, there must be
good reason why these contracts have existed for millennia to facilitate trade across
time. With respect to those who believe that derivatives are new innovations, we
see that their timing is only off by three or four thousand years—but what are a few
thousand years among friends?
We start our study with the simplest and the most basic derivatives, forwards
and futures. First we introduce forward contracts that trade in the over-the-counter
market. Next we discuss futures contracts. Forward and futures contracts are fra-
ternal twins, for the two derivatives are very similar but not identical. We explore
their similarities and differences, then we take a bird’s-eye view of how a company
uses forward (and futures) contracts for hedging input and output price risk, a topic
discussed in greater detail in chapter 13.

4.2 Forward Contracts

Intuitively, a forward contract locks in a price today for a future transaction—
contract now, transact later is the mantra. More formally, a forward contract or a
forward is a binding agreement between a buyer and a seller to trade some com-
modity at a fixed price at a later date. This fixed price is called the forward price
(or the delivery price, usually denoted by F), and the later date is the delivery
date (or the maturity date, usually referred to as time T). Forward contracts are
derivatives as their values are derived from the spot price of some underlying
commodity.
By market convention, no money changes hands when these contracts are creat-
ed. Such an exchange can only happen if both sides are happy with the terms of the
contract and believe the contract is fair, that is, it has a zero value. To understand
why, suppose the forward had a positive value to the buyer of the commodity. Then
it must have a negative value to the seller. This means that when the seller enters the
forward contract, his wealth immediately declines. He has been hoodwinked by the
buyer! A rational seller would not freely enter into such a contract. A similar argu-
ment holds in reverse if the forward contract has a negative value. Consequently,
if no money changes hands when the contract is created, it must have a zero value.
As such, the delivery price written into the contract must be a fair price for future

1
See chapter 8 for an in-depth history.
 FORWARD CONTRACTS 85

trading of the asset. How do we find this delivery price? It’s actually quite straight-
forward. Chapters 11 and 12 will show how to find this price using some basic
economic principles.
Derivatives trade on an exchange or in an over-the-counter (OTC) market. Like
a magician pulling a hare out of his hat, derivatives also get created out of thin air!
Indeed, they are created when one party wants to trade a particular derivative,
finds another party to take the other side of the transaction, negotiates a price,
and completes the deal. This observation highlights a classic characteristic of
derivatives—they trade in zero net supply markets. A derivative does not exist
until a trade takes place—unlike stocks, the buyer’s and seller’s positions net out,
leaving the net supply of derivatives at zero. As such, trading derivatives is also a
zero sum game. What one side of the contract gains, the other side loses, and vice
versa.
Some market jargon is useful in understanding derivative transactions. If you
agree to buy at a future date, then you take a long position or you are going long.
If you agree to sell at a future date, then you are taking a short position or you are
going short. A forward buyer is bullish while a forward seller is bearish about the
direction of the price of the underlying commodity. Consider the following ex-
ample of a forward contract.

EXAMPLE 4.1: The Life of a Forward Contract

N Today is January 1. Ms. Longina Long longs to buy some gold at a fixed price in the middle of the
year. Forwards trade in the OTC (interbank) market, where Long’s broker finds Mr. Shorty Short.
Long and Short agree to trade fifty ounces of gold at a forward/delivery price of $1,000 per ounce on
June 30 at a mutually convenient place (see Figure 4.1).
N When the contract begins, its delivery price is adjusted so that the contract is executed without ex-
changing cash. Consequently, the delivery price is fair, and the market value of the contract is zero
at the start.
N Thus a derivative (forward contract) gets created through mutual agreement. The brokers collect com-
missions from the traders for their matching service.
N If Long and Short want, they can close out their positions early through mutual agreement. Theoretically
speaking, they can sell their respective sides of the trade to other investors in the secondary market. Prac-
tically speaking, it’s a hard task. Surely they can trade with others to stop price risk, but credit risk will
remain. If they don’t close out their positions early, Long and Short meet on the maturity date of June 30.
N What happens on June 30 depends on where the spot settles on that fateful day. Because they agreed
on physical delivery, Short sells fifty ounces of gold to Long at $1,000 per ounce. Had they decided
on cash settlement instead, the loser would have paid the price difference to the winner. If the spot
price of gold is higher than the delivery price of $1,000 per ounce, then Long wins and Short loses—
Long pays less for gold than it’s worth in the spot market. Conversely, if the spot price of gold is lower
than $1,000 per ounce on June 30, then Long loses and Short wins—she pays more for that gold than
it’s worth in the spot market. The forward contract terminates after delivery.
86 CHAPTER 4: FORWARDS AND FUTURES

FIGURE 4.1: Timeline for a Forward Contract

Now (start date) Intermediate dates Delivery/maturity date

(Time 0 = January 1) (Time T = June 30)

Long agrees to buy 50 Traders can close out Long buys gold for $1,000
ounces of gold on June 30, positions by making a from Short.
which Short agrees to sell. reverse trade (sell if long, If gold price >$1,000, Long
buy if short). wins. If gold price <$1,000,
Short wins.
No money is paid now. If they don’t close out Zero–sum game-one’s gain
positions, they meet on is the other’s loss.
June 30.
They negotiate the forward Long’s payoff S(T) – $1,000.
price F = $1,000 and Short’s payoff
contract terms.* – [S(T) – $1,000].

* Prices are per ounce

We will now summon the power of algebra to understand these concepts and
develop formulas for Long’s and Short’s payoffs on the maturity date. Before
doing so, though, let’s adopt some conventions that will be useful (see boxed
insert).

TABLE: Conventions
(used unless otherwise noted)
N Prices are for one unit of an asset or a commodity. Multiply by the contract size to get
the total value of the transaction.
N We start at time 0.
N We will often suppress arguments like t and T to reduce clutter. For example, we
denote F(t, T) by F(t) or F.
 FORWARD CONTRACTS 87

Figure 4.1 gives the key dates in a forward contract. Because there are no
intermediate cash inflows or outflows to a forward contract, we can just focus
on the beginning and the end. Suppose the forward starts today. Remember our
mantra contract now, transact later—we need two symbols to capture “now”
and “later.” Let F(t, T) be the forward price (or delivery price) that we decide
now (time t) for a transaction later on the delivery date (T). The first symbol, t,
indicates the date the forward price is quoted, and the second argument, T, gives
the delivery date. To keep things simple, we will usually start our clock at time
t  0. The forward price is F(0, T). To reduce clutter, we will often write F(t, T)
or F(0, T) as F.2
How is the delivery price linked to the forward price? When the contract starts,
by definition, the forward price equals the delivery price, denoted by F. The delivery
price remains fixed over the life of the contract. The forward price, which is the deliv-
ery price of newly written contracts, can, of course, change. If we had waited a day
and entered into a new forward contract tomorrow (date t  1 or date 1) for buy-
ing gold at the same delivery date T, the price might be different. The new delivery
price or the forward price is F(t  1, T) or F(1, T). But that’s not our price. We are
committed to pay F(0, T) at time T. Fair or foul, we have to live with our agreed on
delivery price until the contract matures.
Let S(.) be the spot price (or cash price) of the commodity for an immediate
(spot) transaction. Generically, S(t) is the spot price at any time t; it takes values
S(0) at date 0 and S(T) on the delivery date T. We can call up a broker and easily
get S(0), but who can foretell what S(T) will be on the delivery date? No one can
exactly because the spot price on the delivery date is random and unknown. In
fact, if you could predict stock prices correctly, using derivatives, you’d become a
multimillionaire quickly.
As a result, standing in the present, we don’t know the value of the forward con-
tract to the long position holder at the delivery date (T). So we write

Long’s payoff at the delivery date T

 [S(T)  F] (4.1)

If there’s physical delivery, the long gets a commodity worth S(T), which she can
immediately sell. This is shown with a positive sign. She pays the delivery price F.
This payment enters with a negative sign.
If there’s cash settlement, the long gets S(T)  F from the short when S(T) > F
and pays F  S(T) if S(T) < F:

Short’s payoff at the delivery date T

 [S(T)  F]

 F  S(T) (4.2)

2
For simplicity, we ignore market imperfections like transaction costs, taxes, and convenience yields
from holding a long position in the underlying asset. We will include these market imperfections in
later chapters.
88 CHAPTER 4: FORWARDS AND FUTURES

With physical delivery, the short gets paid the delivery price F, a cash inflow. He
surrenders to the long an asset that’s worth S(T) in the market.
If the contract is cash settled, then the short gets F  S(T) if F > S(T); otherwise,
she pays S(T)  F to the long.
Notice that the long’s and short’s payoffs are exactly equal and opposite. As
mentioned previously, forward contracts are zero-sum games—if you add up the
two payoffs, the net result is zero.

EXAMPLE 4.1(Continued): Payoffs to a Long and Short Forward Contract

N We revisit Example 4.1 again, but this time using notation. Today is January 1 (date 0). The forward
price on which Ms. Long and Mr. Short agree for delivery on June 30 (date T) is F(0, T)  F  $1,000
(all prices are for an ounce of gold).
N Suppose the spot price on the delivery date T is S(T)  $1,005. Long’s forward payoff on delivery
is (1,005  1,000)  $5 or a gain of $5. Long pays $1,000 for gold worth $1,005 in the spot market.
Short’s forward payoff at time T is (1,005  1,000)   $5 or a loss of $5. The contract forces short
to accept this below-market price for gold on the delivery date.
N If, instead, S(T) is $990 on the delivery date, then Long’s payoff at delivery is (990  1,000)   $10
or a loss of $10. She pays $1,000 for gold worth only $990 in the market. Short’s payoff at delivery is
(990  1,000)  $10 or a gain of $10. Observe that for each possible spot price S(T), the long’s and
the short’s payoffs add to zero, confirming the zero-sum nature of this trade.
N The profit and loss for long’s and short’s forward positions on the delivery date (time T) are graphed
on the profit diagram in Figure 4.2. The x axis plots the spot price of gold (S[T]) on the delivery
date, while the y axis plots the profit or loss from the forward contract.
N The payoff to Long is a dashed straight line, making a 45 degree angle with the horizontal axis and
cutting the vertical axis at a negative $1,000, which is the maximum loss. This happens when the
spot (gold) is worthless, but Long still has to pay $1,000 for it. Above this, each dollar increase in the
spot price cuts Long’s loss by a dollar. If gold is worth $1, then Long’s loss is 1,000  1  $999. If it’s
worth $800, then the loss is $200. Ms. Long and Mr. Short break even at $1,000. If the gold price ends
up higher than $1,000 on the delivery date, then Long sees profits. Figure 4.2 shows that the profit
potential for a long forward position is unbounded above.
N The payoff to Short is the downward sloping dashed straight line, making a negative 45 degree
angle with the horizontal axis. Considering the horizontal axis as a mirror, Short’s payoff is the
mirror image of Long’s payoff. When gold is worth 0, Short makes $1,000, as worthless gold is
sold for $1,000. Thus Short’s payoff line touches the vertical axis at $1,000. For each dollar in-
crease in gold’s price, Short’s profit declines by a dollar. If gold is worth $1, then Short’s profit will
be 1,000  1  $999, and so on. If gold increases beyond $1,000, then Short starts losing money.
Short’s maximum loss is unbounded—if gold soars, Short plunges into the depths of despair! This
shows the risks of naked short selling (short selling without holding an offsetting position in the
underlying asset).
 THE OVER-THE-COUNTER MARKET FOR TRADING FORWARDS 89

FIGURE 4.2: Profit Diagram for Forward Contract

on the Delivery Date

Profit

$1,000 Long forward

45o
0
S(T), spot price on
F = $1,000 the delivery date

Short forward
-$1,000

4.3 The Over-the-Counter Market for

Trading Forwards
The OTC derivatives market has seen tremendous growth over the last four decades.
Gigantic markets exist for foreign exchange (“forex”) forwards, money market in-
struments, and swaps. This is a market for the “big guys”—the banks—with excel-
lent credit ratings. As such, it is often called the interbank market. The participants
trade by telephone, telex, and computer, and they tend to be located in the world’s
major financial centers such as London, New York, and Tokyo. Example 4.2 shows
a typical transaction in the forex (foreign exchange) forward market.

EXAMPLE 4.2: Trading Currency Forward

The Contract
N Suppose a US company has bought a machine worth _3 million from a German manufacturer with
payment due in three months. The treasurer of the US company feels that at $1.4900, the euro is at-
tractively priced in the spot market.3 But he doesn’t know what will happen in three months time;
for example, if a euro costs $1.6000, his company will pay an extra $330,000.
90 CHAPTER 4: FORWARDS AND FUTURES

N The treasurer would like to pay today, but the company is short of cash. He checks the forward mar-
ket and finds that DeutscheUSA (a fictitious name), a large commercial bank, bids euros for $1.5000
and offers euros for $1.5010 in three months’ time (see Figure 4.3). He readily agrees and locks in
a price of $1.5010  3,000,000  $4,503,000 for the machine. This forward market trade allows the
treasurer to eliminate exchange rate risk from the transaction so that the business can focus on its
core competency.

The Dealer’s Hedge

N How does DeutscheUSA protect itself? Having far-flung operations and diverse customer bases, big
banks can often find another firm to take the other side of the transaction. Suppose DeutscheUSA
has branches in Germany. Contacting its customer base, DeutscheUSA finds a German importer
hoping to buy _3 million worth of computer parts from the United States in three months’ time. To
shed foreign exchange risk, the German importer agrees to buy _3 million for $1.5000  3,000,000
 $4,500,000.
N DeutscheUSA has done something cool. It has removed price risk for both the US and German
importers and managed to earn a riskless spread of (1.5010  1.5000)  3,000,000  $3,000 in the
process! Skillful dealers try to perfectly offset such OTC trades.
N In reality, such perfect offsets are unlikely, and DeutscheUSA may have residual price risk after net-
ting out all of its foreign currency transactions. Moreover, DeutscheUSA has some credit risk if any
counterparty fails, and it will have to keep tab of the transactions until the deal is done. If it desires,
DeutscheUSA may hedge any residual net exposure with forex futures or by entering into a forward
transaction with another dealer in the forex market.

3
The International Organization for Standardization, or the ISO, has established three-letter codes for representation of
currencies and funds. ISO’s currency codes are USD for the US dollar, AUD for the Australian dollar, EUR for the euro, JPY
for the Japanese yen, GBP for the UK pound sterling, etc. When no confusion arises, we will use commonly used expressions
(and symbols) like dollar ($), euro (_), yen (¥), and pound sterling or pound (£).

OTC market participants may be classified as brokers, dealers, and their clients.
Usual clients are banks, corporations, mutual funds, hedge funds, insurance com-
panies, and other institutions. Many banks act as dealers and make markets in a
variety of derivatives. Sometimes clients call up dealers for quotes. Typically a deal-
er’s sales force makes regular cold calls to potential and existing clients, trying to
sell their derivatives products. Owing to competition, simple derivatives like cur-
rency forwards aren’t very lucrative. Banks’ proprietary trading desks make more
profits when they can identify some special client need and create a customized
product. Big players have trading or dealing rooms, where trading desks dedicated
to spot, forward, and options trading are located. Forward prices are quoted in
terms of a bid and ask, and because there are no specified delivery months like June
and September, forward prices get quoted for delivery in one, two, three, six, or
more months from the current date. Recently, owing to new financial regulations,
many banks are deemphasizing proprietary trading and focusing more on their
dealership businesses.
 THE OVER-THE-COUNTER MARKET FOR TRADING FORWARDS 91

FIGURE 4.3: Intermediary’s Role in the Forward Transaction

Initially

U.S. Co. needs to buy

German machines worth Faces currency risk
€3 million in three months
German importer needs to
Faces currency risk buy computer parts from
U.S. in three months

After DeutscheUSA Enters

Deutsche USA
(dealer)

U.S. Co. agrees to buy €3 $1.5010 per euro

Seller
millions in three months
(Short)

German importer needs Buyer

dollars and agrees to sell (Long)
€3 million in three months $1.5000 per euro

Deutsche USA has perfectly hedged its book and earns $3,000 spread. It has credit risk
but no price risk.
92 CHAPTER 4: FORWARDS AND FUTURES

4.4 Futures Contracts

Forward and futures contracts are fraternal twins. Both involve an exchange of
cash for an asset purchased at a later date but at prices negotiated at the start of
the contract. Yet their differences (explored in Table 4.1 and Figure 4.4) make it
hard to label them as identical. Just as a variety of features like air bags, antilock
brakes, power steering, and seat belts make a car easier and safer to drive, a number
of added features make futures easier and safer to use. You may view futures as a
standardized forward or a forward as a customized futures.
Unlike a forward contract, a futures trades on an organized exchange, which is
a regulated marketplace where buyers and sellers gather to trade a “homogeneous
product.” The federal Commodity Futures Trading Commission and the industry’s
National Futures Association regulate commodity exchanges in the United States.
In contrast, a forward trades in the OTC market, where no regulator tells them the
dos and don’ts.
An exchange standardizes futures contracts for easy trading. A trader only has
to tell how many contracts to buy or sell and at what price. Standardization helps
create a secondary market. It reduces transaction costs and makes futures mar-
kets more liquid. A short can easily close out her position before delivery by going
long the same contract with another trader, who becomes the new short, while the
original long position remains undisturbed. In fact, most futures are closed out
before delivery. This happens because making physical delivery is a costly exercise,
and closing out futures early avoids this expense. If, for some reason, a position
remains open until maturity, then delivery must take place on one of several dates
during the delivery period. The details of this delivery procedure are discussed in
chapter 9.

TABLE 4.1: Comparison of Futures and Forward Contracts

Futures Forward
a. Regulated Largely unregulated
b. Trades in an organized exchange Trades in an OTC market
c. Standardized Customized
d. Usually liquid and has a secondary market Illiquid and has virtually no secondary market
e. A range of delivery dates Usually has a single delivery date
f. Usually closed out before maturity to avoid Usually ends in physical delivery or cash settlement
taking physical delivery
g. Guaranteed by a clearinghouse and has no No such guarantee and has counterparty credit risk
credit (counterparty) risk
h. Trading among strangers; individual’s Forward traders know each other and usually have high credit rating
creditworthiness is irrelevant or require collateral
i. Requires margins (security deposits) No margin requirements (but collateral may be required)

j. Small transaction costs Transaction costs are high

k. Settled daily Settled at maturity
 FUTURES CONTRACTS 93

FIGURE 4.4: A Diagram of a Futures Contract

CFTC, NFA regulate

Broker, Exchange, Clearinghouse monitor

… …

Daily margin payments throughout contract life

… … … … … … … …

Starting date Intermediate dates Delivery/maturity

period

Contrast this with a forward contract, which is privately negotiated between two
traders. As such, the costs of transacting are high. Early termination requires the
consent of both sides—you cannot unilaterally close out a position before delivery.
Consequently, forwards are highly illiquid, have virtually no secondary market,
and are usually held until maturity. Conversely, forwards are tailor-made to suit
counterparties’ needs and objectives. Forwards can be designed and traded even in
situations when no futures contracts are available.
A futures exchange has associated with it a clearinghouse that clears executed
trades and guarantees contract performance by becoming the counterparty to ev-
ery trader. As such, it eliminates counterparty risk in the transaction. The clearing-
house controls its counterparty risk by requiring traders to keep a margin (security)
deposit in their brokerage accounts, which are marked to market and settled at the
end of each trading day. We discuss this in greater detail in chapter 9. By contrast,
a forward contract fixes a price for a future transaction that remains locked in over
the contract’s life, and settlement only takes place on the delivery date.
Futures are primarily designed as risk management tools. They are poor instru-
ments for buying and selling the commodity owing to the hassle of shipping to and
94 CHAPTER 4: FORWARDS AND FUTURES

from delivery points in specific locations like Chicago and New York, which may
ill suit most traders. The US law takes this into consideration and distinguishes
contracts on how they end. If delivery is planned and regularly happens, then the
contract is likely to be classified as a forward; otherwise, it is a futures. During the
1960s and the early 1970s, some brokerage firms were offering off-exchange forward
contracts that were standardized like futures (see Edwards and Ma 1992). Regula-
tors tried to bring them under their jurisdiction, but in 1974, the US Congress denied
such incursions by defining forwards as deferred delivery contracts that naturally
end in delivery, thereby permitting them to trade away from the exchange floor.
Although institutional differences are important, forwards and futures are also
different from an economic perspective because a futures contract has daily cash
flows, whereas a forward only has a final cash flow. This payout feature implies that
futures and forward prices are usually different (see Extension 4.1 on this issue),
but more important, it implies that the risks from holding the contracts differ.
Futures face cash flow reinvestment risk with changing interest rates, whereas for-
wards do not. Because interest rates are random and constantly changing, this rein-
vestment risk is important, and it affects both pricing and hedging considerations.
Futures (and exchange-traded options) have enjoyed enormous growth around
the world. Table 4.2 lists global futures and options volumes for the years 2009 and
2010. Notice that in addition to the older US exchanges, many new international
exchanges, including the Korean Options Futures Exchange (KOFEX), EUREX of
Europe, the International Securities Exchange (IS) of the United States, MexDer
of Mexico, the Dalian Commodity Exchange of China, National Stock Exchange
(NSE) of India, and the Taiwan Futures Exchange (Taifex), rank high on this list.

4.5 Exchange Trading of a

Futures Contract
Next we sketch the trading of a futures contract, which has evolved over time to
efficiently serve user needs. Moreover, this will also help us to understand options
exchanges, which evolved from futures exchanges. We describe open-outcry pit
trading, which is still used at the Chicago Board of Trade (CBOT), the Chicago
Mercantile Exchange (CME or the Merc), the New York Mercantile Exchange
(NYMEX), and the Commodity Exchange, which are designated contract markets
(a technical name for futures exchanges—see chapter 10 for elaboration) operated
by the CME Group. Many experts believe that electronic trading may eventually
replace this method of floor trading.

EXTENSION 4.1: Forward and Futures Prices: The Same or Different?

Forward and futures prices are equal when interest rates are nonrandom and credit risk is absent, as proven by
Cox, Ingersoll, and Ross (1981) and Jarrow and Oldfield (1981). In reality, interest rates are stochastic—they
can wiggle and shift in unpredictable ways owing to myriad factors. This drives a wedge between futures and
forward prices because a futures contract’s cash flows face reinvestment risk, whereas a forward contract’s do
 EXCHANGE TRADING OF A FUTURES CONTRACT 95

not. The reinvestment risk creates uncertainty as to the ultimate payment made for the commodity on the
delivery date. This same uncertainty is not faced by a forward contract, and as such, it becomes a differentiat-
ing factor. Moreover, these contracts have different credit risks. OTC-traded forwards can have substantial
counterparty default risk, but exchange-traded futures have significantly less, giving us yet another reason for
a price difference.
What about the empirical evidence? Naturally a topic like this attracts academic study. An early study
by Rendleman and Carabini (1979) concluded that differences between forward and futures prices on US
Treasury bill contracts were insignificant. In foreign exchange markets, Cornell and Reinganum (1981) and
Chang and Chang (1990) found little difference between forward and futures prices for five currencies—
British pounds, Canadian dollars, German marks, Japanese yen, and Swiss francs. However, Dezhbakhsh
(1994) studied these differences with a larger data set and found significant divergence between the prices
of several currencies. In the case of commodities, Park and Chen (1985) studied gold, silver, silver coins,
platinum, and copper and found significant differences between forward and futures prices. So what can one
conclude? At least based on this sampling of empirical studies, the verdict is still out!
However, it’s important to remember that the crucial distinction between these two contracts is not that
their prices differ but that their risks aren’t the same. The forward has a single cash flow at maturity, whereas
futures have daily cash flows. Consequently, forwards and futures cash flows and values need to be hedged
differently owing to the reinvestment risk. This implies that from a risk management perspective, they are
different securities.

TABLE 4.2: Top Thirty Derivatives Exchanges Ranked by the Number of Futures and Options
Traded in 2010
Rank Exchange January–December 2009 January–December 2010 % Change
1 Korea Exchange 3,102,891,777 3,748,861,401 20.8
CME Group (includes
2 2,589,555,745 3,080,492,118 19.0
CBOT and NYMEX)
3 Eurex (includes ISE) 2,647,406,849 2,642,092,726 −0.2
NYSE Euronext (in-
4 cludes US and European 1,729,965,293 2,154,742,282 24.6
Union markets)
National Stock
5 918,507,122 1,615,788,910 75.9
Exchange of India
6 BM&FBOVESPA 920,375,712 1,422,103,993 54.5
CBOE Group (includes
7 1,135,920,178 1,123,505,008 −1.1
CFE and C2)
NASDAQ OMX
8 (includes US and 815,545,867 1,099,437,223 34.8
Nordic markets)
Multi Commodity
9 Exchange of India 385,447,281 1,081,813,643 180.7
(includes MCX-SX)
96 CHAPTER 4: FORWARDS AND FUTURES

TABLE 4.2: (Continued)

Russian Trading
10 474,440,043 623,992,363 31.5
Systems Stock Exchange
Shanghai Futures
11 434,864,068 621,898,215 43.0
Exchange
Zhengzhou Commodity
12 227,112,521 495,904,984 118.4
Exchange
Dalian Commodity
13 416,782,261 403,167,751 −3.3
Exchange
Intercontinental
Exchange (includes
14 263,582,881 328,946,083 24.8
US, UK, and Canadian
markets)
Osaka Securities
15 166,085,409 196,350,279 18.2
Exchange
16 JSE South Africa 174,505,220 169,898,609 −2.6
Taiwan Futures
17 135,125,695 139,792,891 3.5
Exchange
Tokyo Financial
18 83,678,044 121,210,404 44.9
Exchange
19 London Metal Exchange 111,930,828 120,258,119 7.4
Hong Kong Exchanges
20 98,538,258 116,054,377 17.8
and Clearing
ASX Group (includes
21 82,200,578 106,386,077 29.4
ASX and ASX 24)
Boston Options
22 137,784,626 91,754,121 −33.4
Exchange
23 Tel-Aviv Stock Exchange 70,914,245 80,440,925 13.4
London Stock Exchange
24 Group (includes IDEM 77,490,255 76,481,330 −1.3
and EDX)
Mercado Español de
25 Futuros y Opciones 93,057,252 70,224,176 −24.5
Financieros
Turkish Derivatives
26 79,431,343 63,952,177 −19.5
Exchange
Mercado a Término de
27 51,483,429 62,046,820 20.5
Rosario
Singapore Exchange
28 (includes Sicom and 53,237,389 61,750,671 16.0
AsiaClear)
China Financial Futures
29 0 45,873,295 NA
Exchange
30 Bourse de Montréal 21,937,811 30,823,273 40.5
Note. Ranking does not include exchanges that do not report their volume to the Futures Industry Association (FIA).
Source: “Annual Volume Survey” available at “Trading Volume Statistics” section of Futures Industry Association’s website ([Link]/
downloads/Volume-Mar_FI%28R%[Link]).
 EXCHANGE TRADING OF A FUTURES CONTRACT 97

EXAMPLE 4.3: Exchange Trading of Futures Contracts

Order Placement
N Today is January 1. Ms. Longina Long and Mr. Shorty Short are trying to do the transaction of
Example 4.1 with exchange-traded futures contracts. They both want to trade fifty ounces of gold at
a fixed price on June 30.
N Gold futures trade on the NYMEX and the CBOT, both divisions of the CME Group, and on other
exchanges. During regular hours, transactions occur on the exchange’s trading floor. Each regular
contract is for one hundred troy ounces of gold, but there are also some mini-contracts of smaller
size. No gold futures contract matures in June. There are contracts for April and July, but these
months may not suit Long’s buying needs or Short’s selling desire. Standardization allows quick
trading, but there is a trade-off in that it reduces available choices.
N Futures traders must first open margin accounts (security deposits in the form of cash or some
acceptable securities) with a Futures Commission Merchant (FCM).4 Old-fashioned Shorty calls
up his FCM and dictates a market order to sell one July gold futures at the best available price. The
FCM’s representative records and time stamps his order and sends it to a clerk on the exchange’s
trading floor (see Figure 4.5).
N Technologically savvy Longina submits her market order through an FCM’s website. Futures trad-
ers can place their orders in many other ways besides market orders (see Example 5.8 and Exten-
sion 5.2 of chapter 5 for different order placement strategies). From FCM’s processing center, the
web order is forwarded via computer to a clerk on the trading floor. The FCM’s clerk then fills out
an order form and sends it to the floor broker in the trading pit. A floor broker is a trader’s agent
and has a fiduciary responsibility to protect a client’s interests. He earns a commission for his
service.
N A trading pit or a ring has a circular or a polygonal shape with concentric rings of steps flowing in-
ward to a central place. Inside the pit jostle a motley group of floor brokers, floor dealers, exchange
officials, clerks, market analysts, journalists, and others. Rules require open-outcry trading—the
floor broker or the dealer has to cry out the bid (a proposal to buy) or ask (or offer, a proposal to
sell) in the trading pit so that others may participate. Usually this information is also conveyed by
hand signals. In more advanced systems, prices are displayed via computer terminals and electronic
boards.
N The objective of a single-location market with traders shouting is to give everybody a chance to
participate, hoping that this will lead to greater transparency and better price discovery. Moreover,
quote boards on the floor help with information dissemination.

Trade Execution
N Shorty’s broker in the trading pit checks the quote board and sees that most trades are occurring at a
little over $1,000. He senses the market and cries out an offer to sell one contract at $1,001. Standing
in the crowd is Longina’s broker, who signals the desire to take the other side of this trade. The trade
is executed when they agree on terms.

4
A FCM provides a one-stop service for all aspects of futures trading: it solicits trades, takes futures orders, accepts payments from
customers, extends credit to clients, holds margin deposits, documents trades, and keeps track of accounts and trading records.
98 CHAPTER 4: FORWARDS AND FUTURES

FIGURE 4.5: Open Outcry Pit Trading of Futures Contract

Long Short
Submits buy order Phones sell
via Internet order

Futures Broker
Commission
Merchant

via computer via phone

Exchange

FCM phone desks

Runner takes order and
places on trader’s deck

Pit

Floor broker fills order in a trading pit

open outcry trading takes place

N Next the brokers quickly record the trade on an index card and give it to an exchange employee, who
feeds this information into the exchange’s computer system. Relevant information flashes up on the
large electronic quote boards above the exchange floor and is simultaneously disseminated by ticker
tapes around the globe.
N Long and Short pay their respective broker commissions on a round-trip basis. There is no charge
when entering a position, but the full charge is due at the time the futures transaction is closed. The
amount of commission varies from trader to trader. It could be as low as $10 per round trip trade for
a discount broker but far more for a full-service brokerage firm.

Clearing a Futures Trade

N Before the market reopens, representatives of the clearing members take the trade records to the
exchange’s clearinghouse. The clearinghouse checks the records, and once the records match, the
clearinghouse clears the trade by recognizing and recording it.
 EXCHANGE TRADING OF A FUTURES CONTRACT 99

N The clearinghouse also guarantees contract performance by acting as a seller to every buyer and as a
buyer to every seller (see Figure 4.6). The clearinghouse minimizes default risk by keeping margins
for exchange members, who, in turn, keep margin for their customers.

Settling a Futures Trade

N A stock trade is settled when a buyer pays cash and gets the stock’s ownership rights from the seller.
In contrast, a futures trade has a special feature called daily settlement, by which profits and losses
are paid out daily. At the end of each trading day, a futures position is marked to market by crediting
or debiting the day’s gain or loss, respectively, to a trader’s margin account, an amount that equals
the difference between yesterday’s and today’s futures prices. If the futures price goes up, Long wins;
if it goes down, Short gains.

N Marking-to-market resets the delivery price at maturity for outstanding futures contracts to the cur-
rent futures price in freshly minted futures. This process of marking-to-market also resets the value
of a futures contract to zero at the end of each trading day.

N To understand marking-to-market, suppose Long buys one hundred ounces of gold from Short in July
for $1,001 per ounce. Suppose the next day’s settlement price is $1,004. Long would screech if you tell
her that she now has to buy gold in July at $1,004 because she thought she locked a price of $1,001! How-
ever, she would agree to buy at $1,004 if you were to pay her the price difference between her earlier price
and the new one: ($1,004  $1,001)  $3 per ounce. To handle this payment, $3  100  $300 is taken
from Short’s margin account and deposited into Long’s margin account. Wouldn’t $300 earn daily
interest in a bank account? And wouldn’t such daily receipts or payments happen in an unpredictable
fashion? The answer to both questions is yes. As noted earlier, these observations are what differentiate
futures from forward contracts. Chapter 9 explains how marking-to-market works in greater detail.

FIGURE 4.6: Role of a Clearinghouse in a Derivative

Transaction

301.56........301.
.......103.71.....
99.02.......95.01.

Clearinghouse

Buyer Seller Buyer Seller

(Long) (Short) (Long) (Short)

Derivative trades are executed in an exchange where the buyer and seller meet through brokers.
After a trade is cleared, the clearinghouse becomes a seller to the buyer and a buyer to the seller.
It has counterparty credit risk but no price risk.
100 CHAPTER 4: FORWARDS AND FUTURES

Closing the Contract

N A month later, Longina sells one July gold futures to Miss Tallmadge, closes out her position, and
clears her slate. Her effective selling price after all the marking-to-markets is close to $1,001. Taxes,
interest charges on margin balances, and other market imperfections will make the realized price a
bit different from $1,001. Tallmadge is the new long vis-à-vis Shorty’s short.
N Shorty decides to physically deliver the gold during the contract’s delivery period in July. He delivers
one hundred ounces of gold as per exchange requirements and collects an amount close to $100,100
from Tallmadge.

Futures trading is becoming increasingly popular in different parts of the world,

including in countries that were previously hostile to it. Extension 4.2 discusses
futures trading in some developing countries, with particular focus on Ethiopia,
modern futures exchanges in China, and village Internet kiosks that inform and
empower India’s farmers.

EXTENSION 4.2: Futures Exchanges in China, India, and Ethiopia, and E-Choupal
in Village India

Moving Commodities from Farms to Consumers

When you read Grimm’s fairy tales about the old days, you come across farmers who keep a portion of the
crop for family consumption and sell the rest in the market. Even today, this is true in many parts of the world,
where farmers’ markets are held on a regular basis. But when food moves to towns and cities, you need a sup-
ply chain—a network of storage facilities, transporters, distributors, and retailers that take food from the
farmer and deliver it to the consumer.
Advanced economies use sophisticated technology at each stage of the supply chain to minimize costs and
maintain product quality. For example, fruits and vegetables are flash frozen, sent in refrigerated trucks, and
kept in temperature-controlled warehouses to extend their shelf life. Owing to this process, restaurants can
offer an incredible variety of “fish, flesh, and fowl” such as Maine lobster, Alaskan king crab, Hawaiian ma-
himahi, and Russian caviar. And as Walmart and many other companies have demonstrated, sophisticated
supply chains can significantly lower costs that in competitive markets get passed on to consumers.
However, the story is different when commodities move from rural to urban areas in some of the poorest coun-
tries. Farmers sell their excess crops to a middleman, who acts as a broker or dealer. Visualize the farmers manu-
ally loading crops into sacks, putting them on a bullock-driven cart, taking them to the middleman’s house for
inspection, weighing and packaging, and selling at whatever price they are offered. The produce goes through sev-
eral middlemen before it reaches retail outlets. Significant waste can occur during repackaging and reinspection
by the middlemen, and poor handling and lack of refrigeration can further diminish the quantity. The farmers get
only a small fraction of the final price. True, each of these intermediaries serves a useful economic function, but
they are relevant only because the infrastructure is primitive and sophisticated risk management tools are absent.
 EXCHANGE TRADING OF A FUTURES CONTRACT 101

Futures Trading in China

Consider China, a country home to over 1.3 billion people. During the 1980s and 1990s, China became interested
in developing sophisticated financial markets and institutions. Futures trading began in China in 1993. How-
ever, during the first few years, “new exchanges opened with wild abandon, and speculative volume ballooned”
(Qin and Ronalds, 2005). Eventually, the Chinese authorities closed more than forty of these exchanges. The
Dalian Commodity Exchange, the Shanghai Futures Exchange, the Zhengzhou Commodity Exchange, and
the China Financial Futures Exchange (founded in 2006) are the only operating futures exchanges remaining
in China today. These exchanges are either fully electronic or use a combination of open-outcry and electronic
trading. All four show up in the list of top thirty derivatives exchanges in the world (see Table 4.2 and Figure 4.7).
Interestingly, an October 12, 2009, article in the Wall Street Journal titled “China Targets Commodity Prices
by Stepping Into Futures Markets” reported that the leaders of Communist China are planning to use futures
exchanges “to fight back” foreign suppliers who “inflate [China’s] commodity prices.” China’s rapid economic
growth requires the importation of vast quantities of many commodities: the country buys 10 percent of the
world’s crude oil (making China the second largest importer of oil after the United States), 30 percent of its
copper, and 53 percent of its soybean output. By developing the three commodities exchanges as “major play-
ers in setting world prices for metal, energy and farm commodities,” China expects to be less susceptible to
exchange prices elsewhere.
The article reported that China’s ambitious plan, however, does not immediately threaten exchanges in
Chicago, London, and New York, where benchmark prices for most commodities are set. This is because of
restrictions on foreign participation in Chinese exchanges and the government’s role as both a player and a
policy maker in the markets. Futures traders joke that “China is second only to the weather in driving some
commodity prices—but less predictable.” Chinese futures prices have begun affecting global prices for many
key commodities. For example, Chinese demand was a major contributor to huge swings in crude oil prices
during 2008–9 (see Figure 4.7).

Futures Trading in India

At the start of the new millennium, India removed a four-decade-long ban on commodity futures trading,
allowed resuscitation of moribund exchanges, and approved the opening of new ones. Soon afterward, dur-
ing 2002–3, three major electronic multicommodity exchanges, the National Multi Commodity Exchange
of India Ltd., the Multi Commodity Exchange (MCX), and the National Commodity and Derivatives
Exchange Limited were formed. As Table 4.2 depicts, the Multi Commodity Exchange and the National
Stock Exchange of India ranked among the world’s top ten derivatives exchanges in terms of trading volume
in the year 2010.
In yet another development, September 2010 saw the opening of the United Stock Exchange (USE) of India.
Backed by government and private banks as well as corporate houses, the USE currently offers trading in cur-
rency futures (on-the-spot exchange rate of Indian rupees against the dollar, euro, pound sterling, and yen)
and options (on the US dollar Indian rupee spot rate) but plans to expand its offerings to include interest rate
derivatives.5 Despite its limited product line, the USE was ranked thirteenth in terms of the total number of
derivatives contracts traded during the first six months of 2011.6

5
See [Link]/[Link]#.
6
[Link]/downloads/Complete_Volume%2811-11_FI%[Link].
102 CHAPTER 4: FORWARDS AND FUTURES

FIGURE 4.7: Growing Chinese Influence in Some

Commodity Markets

Taking Off
Size of China’s derivatives markets compared with their Western equivalent,
by number of contracts traded; data in millions
Soybean futures Sugar futures
Dalian Commodity Exchange Zhengzhou Commodity Exchange
CME Group* Intercontinental Exchange
120 160
100 128
80 96
60
40 64
20 32
0 0
2006 ’07 ’08 2006 ’07 ’08

Aluminum futures Copper futures

Shanghai Futures Exchange Shanghai Futures Exchange
London Metal Exchange London Metal Exchange
60 30
48 24
36 18
24 12
12 6
0 0
2006 ’07 ’08 2006 ’07 ’08
* Includes Chicago Board of Trade or CBOT; and New York Mercantile Exchange
or Nymex
Source: From “China Nurtures Futures Markets in Bid to Sway Commodity Prices” by James T. Areddy, WSJ
.com, Oct 12, 2009. Reprinted by permission of The Wall Street Journal. Copyright © 2009 Dow Jones &
Company, Inc. All Rights Reserved Worldwide.

Commodity futures exchanges have also been founded in many other countries, including those in Latin
America, Eastern Europe, and Asia. However, Africa has been slow in adopting futures trading. Next we con-
sider the inspiring story of an exchange in Ethiopia that opened for business in 2008. Notice that China’s and
India’s stories mostly center around institutional players and other sophisticated traders. By contrast, the
following two cases consider using derivatives to help improve the standard of living of rural folk.

An Ethiopian Commodity Exchange

Consider Ethiopia, whose fertile lands are capable of growing abundant wheat and corn. Yet it is one of the
world’s poorest countries. Ethiopian farmers failed to take advantage of soaring global grain prices. Low edu-
cation, poor infrastructure, civil conflicts, and unstable neighbors like Sudan, Somalia, and Eritrea (with
whom Ethiopia fought a war over border disputes) contribute to the country’s woes.
 EXCHANGE TRADING OF A FUTURES CONTRACT 103

As written in the Wall Street Journal (“Ethiopia Taps Grain Exchange in Its Battle on Hunger,” February
27, 2008), Ethiopia opened the modern Ethiopia Commodity Exchange (ECX) in April 2008, the first of its
kind in Africa and the only functioning commodities exchange outside South Africa. The $21 million project
was inaugurated with the support of the Ethiopian government ($2.4 million), the World Bank, some United
Nations agencies, the International Food Policy Research Institute (IFPRI), and individual countries such as
the United States.7 Eleni Zaude Gabre-Madhin, who worked for the World Bank before returning to her native
Ethiopia as the program leader of Development Strategy and Governance for IFPRI, has been the driving force
behind this exchange and has served as its first chief executive officer.
ECX’s objective is to stop farmers from getting exploited by middlemen and to link them directly with
global markets. Heavily influenced by the CBOT, ECX introduced a system of open-outcry floor trading for
six agricultural commodities. The farmers take their crops to one of the many warehouses that ECX has set
up across the nation, have them weighed and graded, and get a warehouse receipt (for the deposited grain),
which they can sell immediately or at a later date at the commodities exchange. Electronic screens set up in
twenty market towns disseminate real-time grain prices at several different places across the world (including
Ethiopia’s capital Addis Ababa and the exchanges in London and Chicago). The farmer’s selling price becomes
an informed choice.
Following the path trodden by the CBOT 160 years back, ECX began with spot trading and plans to add fu-
tures trading (see “Rising Prices and the Role of Commodity Exchanges,” Wall Street Journal, April 17, 2008).
The Wall Street Journal article reports that Gabre-Madhin saw strong parallels between the current situation
in Ethiopia and the state of the American farm trade before the CBOT was formed. She expects ECX to bring
“the same innovations the Board of Trade brought the US: uniform quality standards, fair ‘price discovery’ and
futures contracts.”

E-Choupal in India
What does India’s largest cigarette maker have to do with Internet kiosks in rural India? Previously known
as Imperial Tobacco Company of India Ltd., ITC Ltd. has annual revenue of over $5.1 billion and has “a
diversified presence in Cigarettes, Hotels, Paperboards & Specialty Papers, Packaging, Agri-Business, Pack-
aged Foods & Confectionery, Information Technology, Branded Apparel, Personal Care, Stationery, Safety
Matches and other FMCG [Fast Moving Consumer Goods] products.”8 ITC’s agri-business division, which is
one of the largest exporters of agricultural commodities in India, runs e-Choupals in over six thousand vil-
lages and expects to reach one hundred thousand villages over the next decade.
Building on the term choupal, which refers to the meeting place in the village, e-Choupal is a desktop
computer with an Internet connection that links farmers to a variety of services. It is the brainchild of ITC’s

7
Founded in July 1944 at the Bretton Woods conference, the World Bank Group consists of five closely associated institutions that
are owned by their member countries. Their mission is to “fight poverty and improve living standards of the people in the develop-
ing world.” Two of these five, the International Bank for Reconstruction and Development, which “makes loans and grants and
provides analytical and advisory services to middle-income and creditworthy poorer countries,” and the International Development
Association, which “offers interest-free credits and grants to the world’s 81 poorest countries,” are referred to as the World Bank
([Link]). The United Nations (UN) is a multipurpose international agency that was founded in 1945 with the aim
of (see the UN Charter) ending wars, upholding fundamental human rights, establishing justice, honoring treaties and international
law, and promoting “social progress and better standards of life in larger freedom” ([Link]/aboutun/charter /index).
8
[Link]/sets/itc_frameset.htm.
104 CHAPTER 4: FORWARDS AND FUTURES

chairman Yogesh Chander Deveshwar. Wildly enthusiastic about the project, Deveshwar even predicted that
e-Choupal would be more important to the company than cigarettes in five years’ time.
Implementation of e-Choupal has been difficult owing to a shortage of “phone lines, electricity and liter-
ate farmers,” notes an article titled “Cigarettes and Virtual Cathedrals” (Economist, June 3, 2004). ITC has
overcome these problems with VSAT satellite links, solar batteries, and carefully chosen sanchalaks, or “con-
ductors,” who are educated local farmers in charge of running e-Choupals. The article describes e-Choupal’s
functioning in a village in the Indian state of Madhya Pradesh as follows:
In Badamungalaya, farmers use the e-CHOUPAL to check prices for their soya beans at the nearest
government-run market, or even on the Chicago futures exchange. They look at weather forecasts. They
order fertilizer and herbicide, and consult an agronomist by e-mail when their crops turn yellow. Some
buy life insurance. The local shopkeeper orders salt, flour and sweets. Two wealthy villagers have even
bought motorcycles. Others club together to rent tractors. School children check their exam results.
“Distance has been killed,” says Mr Nagodia [e-Choupal’s sanchalak].
ITC’s website states that the e-Choupal model has been specifically designed “to tackle the challenges posed
by the unique features of Indian agriculture, characterised by fragmented farms, weak infrastructure and the
involvement of numerous intermediaries, among others.”

In futures trading, the terms open interest and trading volume need careful
distinction: trading volume is the total number of contracts traded, whereas open
interest is the total number of all outstanding contracts, which may also be counted
as the total number of long (or short) positions. Trading volume is a measure of a
market’s liquidity: the more the volume is traded, the more active the market is.
In contrast, the open interest is a measure of the market’s outstanding demand for
or exposure to a particular commodity at the delivery date. Example 4.4 further
explores the distinction between these two concepts.

EXAMPLE 4.4: Volume versus Open Interest

N Suppose that a July gold futures just becomes eligible for trading. Heather buys twenty of those
contracts from Kyle. Trade records will show the following (for convenience, they are also shown in
Table 4.3):
- Heather is long twenty contracts.
- Kyle is short twenty contracts.
- Trading volume is twenty contracts.
- Open interest is twenty contracts.
N Heather decides to reduce her exposure. She sells ten contracts to Tate. As a result,
- Heather is now long ten contracts.
- Tate is long ten contracts.
- Kyle is short twenty contracts, as before.
 HEDGING WITH FORWARDS AND FUTURES 105

- Trading volume rises to thirty contracts.

- Open interest is twenty contracts, as before.
N Kyle reduces his short position. He buys five contracts from Heather. Consequently,
- After selling five contracts, Heather is long five contracts.
- Tate is long ten contracts, as before.
- Kyle is short fifteen contracts after this trade.
- Trading volume, which adds up the number of trades, is thirty-five contracts.
- Open interest, which is the sum total of all outstanding long positions (or short positions), is now
fifteen contracts.

TABLE 4.3: Trade Records for Gold Futures Contracts

Kyle sells twenty contracts to Heather
Trader Long Short Trading Volume Open Interest
Heather 20 20 20
Kyle 20
Heather sells ten contracts to Tate
Trader Long Short Trading Volume Open Interest
Heather 10 30 20
Kyle 20
Tate 10
Heather sells five contracts to Kyle
Trader Long Short Trading Volume Open Interest
Heather 5 35 15
Kyle 15
Tate 10

4.6 Hedging with Forwards and Futures

Forwards and futures are widely used for hedging commodity price risks at future
dates. Consider a typical firm, which uses inputs to produce one or more outputs.
Input and output prices are susceptible to price fluctuations. Usually, a firm tries to
shed price risk for both its inputs and outputs, provided it is not costly to do so. Then
it can concentrate on production; in other words, it can focus on what it does best.
Obviously, it is a judgment call to decide which risks to cure and which to endure.
Suppose that to reduce input price risk, a firm sets up a long hedge (or a buy-
ing hedge) by taking a long position in a forward contract. For example, a company
that mines and refines gold in some remote area and uses natural gas to power its
106 CHAPTER 4: FORWARDS AND FUTURES

electricity generators may find it prudent to buy a forward contract on natural

gas. If natural gas prices go up in the future, then the company pays more in the
spot market, but the spot market loss is largely offset by the gain on the forward
contract. On the flip side, if natural gas prices go down, the company will sur-
render some of its spot market gains through losses on the forward position. This
is always the case when one employs a hedging strategy. Hedging with forwards
(and futures) cuts both ways: it reduces the risk of financial loss from adverse price
movements, but also takes away potential gains from favorable price changes.
Alternatively, to reduce output price risk, the company can establish a short
hedge (or selling hedge) by taking a short position in a forward contract. If the
company sells gold forward, then it will remove or lessen the potential for loss (as
well as gains) from future spot price fluctuations. If the spot goes down, then the
company loses money when it sells gold in the cash market, but it profits from the
forward contract. The losses and gains are reversed when the spot price goes up.
Hedging is analogous to purchasing an insurance policy on the commodity’s
price. It pays off when prices move in an adverse direction. But as with all insur-
ance policies, there is a cost—the premium. If the price does not move in an ad-
verse way, you paid for insurance that you didn’t use. This is the cost. Risk-averse
individuals will often buy insurance despite this cost, and analogously, firms will
often hedge their input or output price risk.

4.7 Summary
1. The buyer and seller in a forward contract agree to trade a commodity on some
later delivery date at a fixed delivery (forward) price. Forwards are zero net
supply contracts. Forward trading is a zero-sum game. On the maturity date,
the buyer’s (or the long’s) payoff is the spot price minus the delivery price. The
seller’s (or the short’s) payoff is equal in magnitude but opposite in sign to the
long’s payoff.
2. There are organized OTC (interbank) markets for trading forwards, which are
dominated by banks and other institutional traders. These markets are huge. For
example, foreign currency forwards attract billions of dollars of trade every day
and have outstanding obligations measured in trillions of dollars.
3. The buyer and seller of a futures contract agree to trade a commodity at a fixed
delivery price on the maturity date. A futures contract is similar to a forward.
The long position holder in both these contracts agrees to buy the commodity,
while the short agrees to sell. The forward or futures price is set so that no cash
changes hands when the contract is created. This implies that the contracts have
zero initial value.
4. Exchange-traded derivatives are highly regulated contracts that trade in orga-
nized exchanges. A clearinghouse clears trades and guarantees contract perfor-
mance. Traders are required to keep margins (security deposits) that are adjusted
daily to minimize default risk. Exchanges also act as secondary markets where
traders can take their profits or cut their losses and exit the market.
 QUESTIONS AND PROBLEMS 107

5. Futures are traded on the floor of older exchanges like the Chicago Board of
Trade and the Chicago Mercantile Exchange using an open-outcry method. Of-
fers to trade must be shouted in trading rings or pits so that other brokers and
dealers can hear and join. Exchange employees are also present on the trading
floor to report prices and ensure that the system works well.
6. Many firms reduce price risk by trading futures and forward contracts. A firm
can lower input price risk by setting up a long hedge buying a forward and reduce
output price risk by establishing a short hedge selling a forward.

4.8 Cases
The Dojima Rice Market and the Origins of Futures Trading (Harvard Business
School Case 709044-PDF-ENG). The case blends business history with policy
issues surrounding the introduction of rice futures at the Dojima Exchange, the
world’s first organized (but unsanctioned) futures market.
United Grain Growers Ltd. (A) (Harvard Business School Case 201015-PDF-
ENG). The case considers how a Canadian grain distributor can identify and
manage various risks.
ITC eChoupal Initiative (Harvard Business School Case 297014-PDF-ENG). The
case discusses the use of Internet technologies and derivative contracts to help
poor farmers in rural India.

4.9 Questions and Problems

4.1. Define a forward contract. If a forward contract on gold is negotiated at a
forward price of $1,487 per ounce, what would be the payoff on the maturity
date to the buyer if the gold price is $1,518 per ounce and to the seller if the
gold price is $1,612 per ounce?
4.2. Define a futures contract.
4.3. Discuss the similarities and differences between forward and futures
contracts.
4.4. What are the costs and benefits to a corn grower trading a forward contract?
If she is expecting a harvest in three months, should she buy or sell the
derivative?
4.5. Which contract has more counterparty risk, a forward contract or a futures
contract? Explain your answer.
4.6. Discuss the benefits of standardization of a futures contract.
4.7. What are the two roles that a clearinghouse plays in the case of a futures
contract?
108 CHAPTER 4: FORWARDS AND FUTURES

4.8. Ang, Bong, Chong, and Dong are trading futures contracts. Carefully iden-
tify the trading volume and open interest for each trader from the following
transactions:
a. Ang buys five October silver futures from Bong.
b. Chong sells nine December silver futures to Bong.
c. Dong buys ten October silver futures from Chong.
d. Bong sells five December silver futures to Ang.
e. Ang sells three October silver futures to Chong.
4.9. Suppose you are a trader specializing in futures on corn, wheat, oats, barley,
and other agricultural commodities. From the following list, which risks do
you face (mark each with a yes or no): credit risk, market risk, liquidity risk,
settlement risk, operational risk, legal risk.
4.10. For forward and futures contracts, what is the difference between physical
delivery and cash settlement?
4.11. Why does a futures contract have zero value when it is first written?
4.12. What is marking-to-market for a futures? Why is this marking-to-market
important for reducing counterparty risk?
4.13. Explain why a futures contract is a zero-sum game between the long and
short positions.
4.14. Are forward contracts new to financial markets? Explain.
4.15. Can you think of a reason why forward prices and futures prices on otherwise
identical forward and futures contracts might not be equal?
4.16. What is the OTC market for trading derivatives? How do OTC markets dif-
fer from exchanges?
4.17. When holding a futures contract long, if you do not want to take delivery of
the underlying asset, what transaction must you perform? Explain.
4.18. If you are short a futures contract, why do you not have to borrow the futures
contract from a third party to do the short sale?
4.19. Is the futures price equal to the value of the futures contract? If not, then
what is the value of a forward contract when it is written? Explain.
4.20. Is the forward price equal to the value of a forward contract? If not, then
what is the value of a forward contract when it is written? Explain.