Derivatives: Valuation and Risk Management

By David A. Dubofsky; Thomas W. Miller Jr. | Go to book overview

CHAPTER 6

Introduction to Futures

In this chapter, we present the essential features of another important derivative security, the futures contract. A considerable amount of terminology and institutional detail surround futures contracts. However, struggling with these details will pay off because these details provide the foundation to understand how futures contracts can be used to manage price risk.

At first, many people think that futures contracts are exactly the same as a forward contract. Although the two instruments are similar, they are not exact substitutes. There are two very important distinctions between these two types of contract. Recall that a disadvantage of a forward contract is that the firm faces the risk of default on the contract by the counterparty. An advantage of a futures contract is that the risk that counterparty default risk is essentially eliminated. However, this benefit comes at a cost. Unlike forward contracts, futures contracts are standardized, which means that they are not as flexible as forward contracts. These distinctions mean that both forward and futures contracts can provide unique risk-shifting benefits.

We begin this chapter with a detailed discussion of the features that distinguish futures contracts from forward contracts. Therefore, a good way to prepare for this chapter is to review Chapter 3, which provides an introduction to forward contracts.


6.1 FUTURES CONTRACTS AND FORWARD CONTRACTS

Speculators use futures to a greater extent than forwards. Speculators buy futures contracts when they believe that the price of the good will rise. Speculators sell futures contracts when they believe that prices will fall. Hedgers also use futures contracts to manage their risk exposure, and arbitrageurs exploit situations when futures prices are sufficiently different from their theoretical values.

For both futures and forward contracts, one party agrees to buy something in the future from a second party; the second party agrees to sell it. The buyer of a contract, who is said to be long the contract, has agreed to buy (take delivery of) the good. The seller is said to be short the contract, and this person has the obligation to sell (deliver) the good at some time in the future. The contract specifies both the quantity and quality of the good, the price, the delivery date or dates, and the delivery location or locations.1

Futures and forwards are in zero net supply; for every buyer of a contract, there is a seller. The profits and losses realized in forward and futures contracting represent a zero-sum game; for every dollar one party makes, another party must lose a dollar (ignoring commissions). However, there are several ways in which futures contracts differ from forward contracts.

1. Futures contracts are standardized; only the price is negotiated. All December 2001 gold futures contracts are identical in that the amount of gold (called the contract size), quality of gold, delivery date, and place of delivery are specified. In contrast, all elements of forward contracts are

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