Forward A forward contract is a bilateral contract that obligates one party to buy and the other to sell a specific

quantity of an asset, at a set price, on a specific date in the future Long forward position: agrees to buy Short forward position: agrees to sell Can be either deliverable or cash settlement contracts Are priced to have zero value at the time an investor enters into the contract Are private contract and do no trade Are customized contracts satisfying the needs of parties involved Contracts between 2 orginating counterparties Usually not regulated Not mark to market F= So*(1+r)^T

Definition

Similarities

Differences

Price at initial F = So*e^(r-)T

Value

Value at expiration: Long: St - F Short: V = F-St

Arbitrage

Cash and carry arbitrage: when the futures/forward price is overvalued (actual market price > noarbitrage price) At initial of the contract: - Borrow money for the term of the contract at market interest rate - Buy the underlying asset at the spot price - Sell (go short) a futures/forward contract at the current futures/forward market price At contract expiration: - Deliver the asset and receive the futures/forward price - Repay the loan plus interest

Arbitrage

Reverse cash and carry arbitrage: when the futures/forward price is undervalued (actual market price < no-arbitrage price) At initial of the contract: - Short sell the underlying asset at the spot price - Lend money (from the short sale of asset) for the term of the contract at market interest rate - Buy (go long) a futures/forward contract at the current futures/forward market price At contract expiration: - Deliver the asset and receive the futures/forward price - Repay the loan plus interest Long asset --> short forward

Hedge

Short asset--> long forward

Futures Futures contracts are essentially exchage-traded forward contracts. They are standardized, and have speific delivery dates, location, and procedures.

g forward position: agrees to buy rt forward position: agrees to sell er deliverable or cash settlement contracts value at the time an investor enters into the contract Traded on organized exchanges Are highly standardized A single clearing house is the counterparty to all futures contracts Regulated Mark to market F= So*(1+r)^T No dividend, discrete compounding - Continous rate - is: dividend yield for stock or stock index, coupon rate for bond or bond index, foreign interest rate if underlying asset is foreign currency, lease rate (convenience yield - storate cost) for commodity

F = So*e^(r-)T

Mark to market (daily, weekly) Value of futures contract = current futures price previous mark-to-market price

e futures/forward price is overvalued (actual market price > no-

ontract at market interest rate ot price ntract at the current futures/forward market price

utures/forward price

when the futures/forward price is undervalued (actual market

he spot price asset) for the term of the contract at market interest rate ntract at the current futures/forward market price

utures/forward price Use index futures to hedge position in stock portfolio: Long stock portfolio: sell futures Short stock portfolio: buy futures number of futures contract to buy/sell = (value of portfolio/notional value of a futures contract) * Portfolio Beta Notional value of a futures contract (S&P 500 index) = $250 * index value

Strategy Call Option Put Option Floors Caps Coverred Call Coverred Put Spreads Bull Spreads Bear Spreads Collars

Position Long Short Long Short Long Asset + Long Put Long Asset + Long Call Short Asset + Short Call Short Asset + Short Put 2 calls or 2 puts Long lower strike call + Short higher strike call Long lower strike put + Short higher strike put Short lower strike call + Long higher strike call Short lower strike put + Long higher strike put 1 call + 1 put

Benefit

Payoff

Max Gain Max Loss