Chapter 11: Futures and Forwards Options

11.1 Introduction

A forward contract is an over the counter private agreement between two counter parties. Primary risk in a forward contract is the counterparty risk of default. Futures contracts are traded on an exchange where the counterparty risk is accounted for by the exchange. The main source of risk in a futures contract is the basis risk. The exchange requires daily settlement of the futures contract in a margin account. The change in the going interest rate will modify the price of the exchange-traded futures contract relative to an identical forward contract.

Usually, there is a slight positive correlation between interest rates and the spot price of the commodity. When the spot price increases, the holder of a long position in a futures contract may withdraw the excess margin. This extra cash can be invested in an interest-rate bond. This investment is favorable as the positive correlation to the spot price implies that the interest rate has also risen.

In contrast, if the spot price declines, then the value of the futures contract has decreased and the holder of the long position may face a margin call. To cover this margin call, money may be borrowed at the current interest rate. The correlation to the spot price indicates that the interest rate has likely decreased, providing a more favorable environment to borrow cash. Thus, the long position in a futures contract is more favorable than a forward contract if the spot price ...

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