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Unformatted text preview: STAT 2820 Chapter 2 Forward Contracts by K.C. Cheung 2.1 Futures Contracts 2.1.1 A forward contract is an agreement between two parties to buy or sell an asset ( un- derlying asset ) at a certain time in future ( delivery date/maturity ) for a certain price ( forward price/delivery price ). The contract is negotiated, agreed and signed today. It fixes all the transaction details in the future. A forward contract is an over-the-counter (OTC) instrument, traded directly and privately between the two parties. There is no public market for forward contracts. 2.1.2 Futures contracts are the same as forward contracts in terms of contract nature. The main difference is that futures contracts are traded on an exchange. The contract terms (underlying asset, contract size, maturity date, etc) are standardized. 2.1.3 The party who agrees to buy the underlying asset is taking a long position ; the other party who agrees to sell the underlying asset is taking a short position . It costs nothing for anyone to enter into a futures contract, i.e. the price of the futures contract is zero . In other words, the two parties will negotiate a delivery price that is fair to both sides. Example (Long position): On January 1, the futures price of gold per ounce is $400, to be delivered in June. Contract size is 100 ounces. If investor ABC buys two such contracts, he/she agrees to buy 200 ounces in June at a price of $400 per ounce. He/She is now taking a long position. Scenario 1: Suppose that the price of gold per ounce is $420 in June. Then ABC could use $80000 (=$400 × 200) to buy 200 ounces rather than using the market price $84000 (=$420 × 200). The profit-and-loss (P/L) is $84000-$80000=$4000. (Another way of thinking: ABC first use $80000 to buy the gold, then immediately sell it to the market at $84000. The profit is $4000) Scenario 2: Suppose that the price of gold per ounce is $380 in June. Then ABC is obligated to use $80000 (=$400 × 200) to buy 200 ounces rather than using $76000 (=$380 × 200). The P/L is $76000- $80000 =- $4000. 2.1.4 In general, the P/L from a long position in a futures contract on one unit of an asset is S T- K , where K is the futures price and S T is the spot price (i.e. price quoted for immediate STAT 2820 Chapter 2 2 settlement) of the asset at time...
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This note was uploaded on 07/30/2011 for the course STAT 3801 taught by Professor Kc during the Fall '11 term at HKU.
- Fall '11