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Unformatted text preview: EC372 Bond and Derivatives Markets Topic #2: Futures Markets I: Basic Ideas R. E. Bailey Department of Economics University of Essex Outline Contents 1 Forward and futures contracts 1 1.1 Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 1.2 Operation of futures markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 2 Arbitrage between spot and forward prices 4 3 Arbitrage in foreign exchange markets 5 4 REPO agreements and markets 5 Reading: Economics of Financial Markets , chapter 14 1 Forward and futures contracts Forward and futures contracts Forward contract: two parties agree today to take a future action Example : seller agrees to deliver a specified good (asset) at a specified place on a specified date; the buyer agrees to take delivery and to make payment. Payment takes place at date T (delivery), but a good faith deposit may be made earlier. F ( t, T ) = price agreed at t for delivery at T . Spot contract: immediate delivery. Spot price: p ( t ) = F ( t, t ) Three categories of traders: 1. Arbitrageurs : exploit spot and forward price differentials 2. Speculators : profit from perceived superior expectations 3. Hedgers : trade to eliminate or reduce future price risk Forward contracts enable traders to eliminate price risk but not performance risk Three categories of traders in forward markets: 1 1. Arbitrageurs seek to exploit price differentials among spot and forward prices in order to make arbitrage profits (risk-free payoffs that require a zero initial outlay). Market equilibrium is usu- ally defined such that arbitrage opportunities are absent, i.e. that arbitrageurs have successfully exploited any such opportunities, with the unintended consequence that their collective actions have driven arbitrage profits to zero. 2. Speculators have the object of securing profit from knowing better than the market what the future will bring forth (Keynes, General Theory , page 170.) 3. Hedgers trade in forward markets to eliminate (or, in practice, to reduce) the risks associated with other production or merchandising commitments. For example, a grain merchant may wish to sell wheat forward adopt a short position in order to guard against the possi- bility that the value of the stored grain will have fallen by the date at which it is sold. A miller, on the other hand, may wish to buy forward adopt a long position in order to guard against a rise in the price of grain before it is needed in the milling process. 1.1 Futures contracts Futures contracts Futures contracts: a special type of forward contracts, designed to facilitate trade in the contracts themselves....
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