What is a forward contract?
It is an agreement to buy or sell a real or financial commodity at a pre-determined date and price.
What are the best main characteristics of a forward contract?
- It is OTC
- There is no $ exchanged before maturity
How do we describe the forward price when the contract is issued?
- The forward price is fixed such that the value of the contract = 0
- The forward price is different for different maturity
What are the disadvantages of forward contracts (3)?
- Getting out of a forward position is difficult because you can’t terminate the contract.
- There is a credit risk of default.
- There are delivery risks.
What is a solution for the inconveniences of a forward contract?
Use a futures contract; it is more flexible.
What are the main specifications of a futures contract? (5)
- There are underlying assets with an exact type and quality.
- There are specified contract sizes.
- There are specificities on the delivery of the contract.
- There are clear contract expiry dates
- Standardization facilitates price comparison and increases the liquidity of contracts.
What are the credit and delivery risk management offered by the exchange for future contracts?
- There is payment of collateral and daily settlement of gains and losses by a clearing house.
- There is a possibility to exit positions at any time.
Describe the process of opening a future position.
1) The investor takes a long or short position.
2) The value of the future at initialization is 0.
3) The investor must place a money collateral in a margin account.
How do you close a futures contract position?
By taking a position opposite to the one taken at the opening.
What is a “front month” future contract?
It is a future contract that has a maturity date near the current date. They are the most liquid contract.
What is the comportement of the delivery price of a forward and a future contract?
- Forward contract: delivery price is fixed during the contract’s life.
- Futures contract: delivery price changes every day.
What is the relation between spot and future price at maturity? What happens if it is not respected?
1) At maturity: spot price = futures price
2) There is an arbitrage opportunity if the spot price < future price at maturity.
What is the arbitrage strategy if the spot price < future price at maturity
An arbitrageur has to buy the asset, short a futures contract, and make delivery for an immediate profit.
What is the settlement price?
- It is the futures price just before the market closes.
- This is the price used in the marking-to-market process.
What is the open interest?
It is the number of open contracts.
Who can initiate delivery?
It is the investor with the short position that can initiate delivery by notifying the central exchange of his intention to deliver.
What happens if the trader with the short position can deliver different qualities of underlying assets?
If the trader delivers different qualities of the underlying assets, the futures will be affected downwards. This is because the trader with the long position is uncertain of the quality provided and is unwilling to accept a high futures price as if there were no such uncertainty.
