Futures, Forwards, and Options introduced with examples

The promise to this article is to secure an understanding of Futures and Forward contracts also Options. This article studies the theory definition for each of which, then, challenges them through practical scenarios. So, let’s focus on this very paramount yet interesting subject and learn it once and for all.

Road Map

1. Forwards and Futures contracts
2. Options
3. Practicing a couple of scenarios

Forwards and Futures Contracts

Definition — In its most simple form, a forward contract is an agreement between two parties to buy or sell an asset at a certain time for a certain price in the future. This is usually traded on the over-the-counter (OTC) market. The parties to this agreement could be either two financial entities or with one of their clients.

Application — Forward contracts are quite popular in Forex trading (currency trading). One can consider that to minimize the risks of foreign currencies.

Scenario 1 — Let’s say company ABC who trades in the United States has to make a large payment of £1,000,000 in 6-months forward. The following table depicts the currency rates for the next 6 months with some example data.

Figure 1 — Spot & Future quotes for USD/GBP exchange

Surely, there could be fluctuation in the two currencies during this time. The company can minimize the risk and hedge against the exchange rate using Forward Contracts. In our case, the ABC company has agreed to buy £1 million pounds for the rate of 1.5532 after 6 months. In other words, the company will buy £1m from the bank when 6-month time matures. Hence, the company has a long forward contract. On the other hand, the bank has a short forward contract — in every forward contract, one party goes long and the other one goes short.

Calculating the payoffs for long positions — Remember, forward contracts do not guarantee not losing money. Consider the sport price declines to 1.5000 when the maturity date comes — no doubt the contract would have a negative value for the company as it requires them to buy GBP for a price more than what the agreement states.

Basically, the payoff or the profit for a long position in a forward contract is formulated as the below (for one single unit of course):

Figure 3 — The payoff formula for a long position in forwards contracts

Therefore, once the spot price declines, we would have the following results:

Figure 4 — The negative value of the contract for the ABC company after 6 months (per unit of an asset)

Now, if the spot price rises, our contract would have a positive value. This is because we can then buy the GBP for the smaller price where the actual market price is bigger.

Figure 5 — The positive value of the contract for the ABC company after 6 months (per unit of an asset)

Calculating the payoffs for short positions — Now let’s see it from the bank point of view from whom our ABC company is obliged to buy GBP at the maturity date. The following formula shows how their payoffs are calculated:

Figure 6 — The payoff formula for a short position in forwards contracts

Therefore, when the ABC company loses money the bank would gain money.

Figure 6 — The positive value of the contract for the bank after 6 months (per unit of an asset)

And the bank will lose money when the company has a positive profit.

Figure 7 — The negative value of the contract for the bank after 6 months (per unit of an asset)

At this point, we will close off the Forward Contract topic and will move on with Future Contracts in the next section.

Scenario 2 — Let’s consider a fabric factory Ed’s Fabric that produces cotton fabrics and sells it to a clothes factory Tim’s Clothes that sell cotton shirts. Obviously they profit on the products that they sell to each other. Let’s say the price for every square meter of fabric is £150.

Figure 8 — Ed’s cotton prices

After a while, a new fabric factory joins the market named Lisa’s Fabric. This causes the price of cotton to drop to £100. Therefore, Ed’s now sells its cotton to Tim’s for £100 per square meter.

Figure 9 — Ed’s cotton price has dropped for £50

When this happens, Tim’s will profit from that for £50 on each unit. Now, imagine the opposite situation where the cotton price has gone up for £50. In this case, it’s Ed’s time to enjoy the profit as they can seel each unit of the fabric for £200 now while Tim’s has to buy it now more expensively than before.

Figure 10 — Ed’s cotton price has gone up for £50

Obviously, these volatilities can cost the parties remarkably when the volume of the transaction is huge. Thus, in order to secure their business against these fluctuations in the future, they go to an investor who will help them to hedge against the market changes. The investor will agree with Ed’s that if the price of a unit of cotton falls below £150, he would pay the difference to Ed’s. And as such if the price rises above £150, he would collect the profits from it. This way, Ed’s Fabric has secured itself against the future volatility with a fixed price — they lock the market at a fixed price.

Figure 11 — the investor will collect the price difference when it goes upper than £150

Figure 12 — the investor will pay the price difference when it goes below £150

Adversely, the investor agrees with Tim’s that if the price of a cotton unit goes above £150, he will pay the extra money, hence Tim’s will pay only £150 as predicted. On the other hand, if the price falls below £150, Tim’s still has to pay it at £150 as agreed and the investor will benefit from the difference.

In conclusion, Ed’s and Tim’s have secured themselves against the potential risks of the market rate, and they have conveyed these risks to the investor now.

Futures contracts — A futures contract is basically an agreement between two parties to buy or sell an asset at a certain time in the future and for a certain price. Hence, this is essentially so much alike the forwards contracts except that they are traded at an Exchange Clearing House, rather, the forwards are traded at an OTC.

Options

Options also are quite appealing to traders. One can trade options both on OTC and an exchange. They come in two different types:

1. Call options — This gives the right to the holder to buy an underlying asset at a certain date for a certain price.
2. Put options — This gives the right to the holder to sell an underlying asset for a certain date and for a certain price.

The price in an options contract is called exercise or strike price and the date mentioned there is called expiration or maturity date.

Options that are traded on an exchange by the majority are the American options, but, there also are the European ones. The main difference between the two is that the American options can be traded at any time up to the maturity date whereas the European ones can only be exercised on the expiration date.

And the main difference between options and futures or forwards is that in options the holder has the right not to exercise the contract, whilst, in a futures or forwards contract, the hold is obliged to exercise the contract when it expires.

The Scenario — Let’s say it’s the middle of July and Joe wants to buy a Call Options contract (usually of 100 shares) for December on Tim’s Factory with a strike price of £700. From the table below, the offer price for December is £55.87. This indicates the price for an option to buy one share.

Figure 13 — Tim’s Factory bid and offer for December

For this, Joe talks to an exchange and then he will have to pay them for £5,587 as per 100 * £55.87 so they can transfer this for the other party. What’s happened so far is that Joe has honored the right to buy 100 shares of Tim’s Factory each priced for £700. Once the December arrives, he’s going to experience either of these scenarios:

1. The price has gone above £700
2. The price has not gone above £700

In the first case, Tim’s Factory would have been rocking the market as the price has gone up, hence, the option will be exercised. So, let’s say now that the Bid price for the stock is now £900, Joe is now able to buy 100 shares for £700 where the market price is now £200 more than that. Therefore, he will profit for £20,000.

Figure 14 — Joe’s profit if the stock price goes above the strike price by December (maturity date)

On the other hand, when the second scenario is the case, the options won’t be exercised. And this is one of the main differences that an options contract has with a futures or forwards one, that, the holder has the right not to exercise the contract.

Practicing a couple of scenarios

In this section, we will practice a few more scenarios so we hopefully nail our understanding from previous sections a little bit more.

Scenario1 — Using Put Options to protect against value fall

Usecase — Assume that Joan owns 2,000 shares of Ed’s Factory that each worth £20. There’s a prediction that in the course of 6 months, there will be some decline in the value of the shares. How would you advise Joan to minimize the risk against this decline?

Solution — One possible solution for Joan is to buy 2,000 Put Options (equals to 20 contracts as to 20 * 100) with the strike price of £20 and the maturity date of six months. In this way, on the expiration date, if the price goes under £20, Joan can exercise the contract and then sell her shares each for £25. Hence, she would profit for £5 on each share.

Scenario 2 — Susanna and Short Forwards Contract

Usecase — Susanna runs her own business for years now. She recently enters into a short forward contract on 150 million GBP. The exchange rate is $1.5300 per GBP. She wants to know how much of gain or loss she would once the contract is ended upon the following conditions:

A) The exchange rate is $1.1500 per GBP

B) The exchange rate is $1.1550 per GBP

Answer — When the exchange rate is $1.1500, that is, $0.03 less than the strike price, Susanna sells its shares for $1.5300. Therefore she profits as to:

Figure 14 — Total profit for Sussan as of the maturity date

On the other hand, when the rate is $1.1550, that is, $0.02 more than the strike price, Susanna sells its shares for $1.5300. Therefore she loses money as to:

Figure 15 — Total loss for Sussan as of the maturity date

And we’re done at this step. I hope this article has given few insights to this amazing world of Capital Market and Investments to those who are interested and new to this area.