Introduction to Corporate Finance

ONLINE CHAPTER

are such that AuAg will pay Bank Oz if the three-month LIBOR six months from now is less than the

fixed rate of 6%. If the three-month LIBOR exceeds 6%, Bank Oz must pay AuAg. The size of the cash

flow is determined by Equation 23.4. For example, if the three-month LIBOR six months from now is

7%, Bank Oz must pay AuAg the following:

$10,000, 000 0.07 0.06 92 / 360

10 .0792/360

$25,106.43

()

()

×−×()

+× 

=

However, if the three-month LIBOR six months from now is 5% rather than 7%, AuAg must pay Bank

Oz $25,233.13.

CONCEPT REVIEW QUESTIONS 23-2

3 If Equation 23.2 does not hold, how might an arbitrageur earn a riskless profit?

4 What is the difference in the timing of cash flows in a forward contract and a spot market

transaction?

23-3 FUTURES CONTRACTS

For companies trying to hedge risk exposures, forward contracts suffer from two important problems: default

risk and liquidity. Futures contracts reduce these problems. Like a forward contract, a futures contract involves

two parties agreeing today on a price at which the purchaser will buy a given amount of a commodity or

financial instrument from the seller at a fixed date in the future. In fact, the contracts are so similar that,

for most purposes, we can use the same pricing formulas to price futures contracts that we used for forward

contracts. Similarly, we can use the same payoff diagram for futures that we used for forwards.

Although futures and forwards serve the same economic function, there are differences in the

characteristics of the two contracts. In contrast to a forward contract, a futures contract is an exchange-

traded contract that promises the delivery of a specified volume of a commodity or financial instrument

on a standardised date of the month in which the contract expires. The futures exchange acts as a

guarantor for all transactions, mitigating the forward contract’s problem of counterparty risk.^5

Because futures exchanges offer a limited set of contracts for trading, futures contracts are relatively

liquid compared with forward contracts.

For example, gold futures contracts are traded on the COMEX. The standard gold futures contract

size is 100 troy ounces. Contracts are available for delivery in the current month; the next two months;

any February, April, August and October falling within the next two years; and any June and December

falling within the next six years.

Table 23.3 provides data on the prices of gold futures contracts on 5 October 2015. The first trade

of the day, called the opening futures price, was $1,137.10 per troy ounce for delivery in October 2015.

5 In practice, the exchange acts as a clearing house, and only transacts with the clearing brokers that are members of the exchange. Thus,

the clearing house guarantees all transactions between it and the clearing brokers. However, clients do not usually have recourse to the

exchange. They transact with the clearing brokers, and are thus taking counterparty risk on the clearing brokers.

LO23.3

The highest price for the day was $1,141.70. The low for the day was $1,132.50 per ounce. The last

October 2015 futures price for the day was $1,138.10 per ounce. This closing futures price is the result of a

$1.0 per ounce increase in the settle price from the previous day, as indicated by the change column. The

closing price is also known as the settlement price, and is used to settle all contracts at the end of each day’s

trading, in a process called marking-to-market (see page 802). The open interest represents the number

of contracts that are currently outstanding. This number changes every day as contracts are bought and

sold. If a trader were to take a long position in gold futures contracts at the settle price of $1,138.10 per

ounce, the total futures price of one contract would be $113,810 ($1,138.10 × 100 troy ounces).

Table 23.4 provides a few examples of the types of available futures contracts, the exchanges on

which they are traded and the face amount (size) of each contract.

TABLE 23.3 GOLD FUTURES PRICES, 5 OCTOBER 2015

Open High Low Settle Change High Low Open int.

Oct 15 1,137.10 1,141.70 1,132.50 1,138.10 +1.00 1,306.00 1,072.80 1,664

Nov 15 1,138.70 1,141.30 1,129.80 1,137.70 +1.00 1,154.90 1,102.50 200

Dec 15 1,137.00 1,141.60 1,129.60 1,137.60 +1.00 1,309.50 1,073.70 294,672

Feb 16 1,138.30 1,142.10 1,131.20 1,138.50 +1.10 1,295.90 1,077.90 52,100

Apr 16 1,138.20 1,142.10 1,132.50 1,139.10 +1.10 1,308.00 1,080.90 22,010

Jun 16 1,139.30 1,142.70 1,135.20 1,139.70 +1.10 1,309.00 1,083.00 16,345

Aug 16 1,137.40 1,141.70 1,137.40 1,140.40 +1.10 1,281.50 1,085.20 4,558

Dec 16 1,145.50 1,145.50 1,139.00 1,142.00 +1.10 1,314.00 1,087.50 13,225

Feb 17 1,140.00 1,140.00 1,140.00 1,143.00 +1.10 1,222.70 1,101.60 158

Dec 18 1,158.50 1,158.50 1,158.50 1,161.70 +0.30 1,314.30 1,137.20 860

Dec 19 1,173.00 1,173.00 1,171.00 1,178.30 –0.70 1,283.00 1,168.00 1,400

Note: Estimated vol. 127,241; vol. n.a.; open int. 421,506, n.a.

Source: The Wall Street Journal. Used with permission. SIX Financial Information; WSJ Market Data Group; historical data prior to 6/15/11: Thomson Reuters; WSJ Market Data Group.

TABLE 23.4 EXAMPLES OF EXCHANGE-TRADED FUTURES CONTRACTS

Contract Exchange Face amount

Grains and oilseeds

Corn Chicago Board of Trade 5,000 bushels

Oats Chicago Board of Trade 5,000 bushels

Wheat Chicago Board of Trade 5,000 bushels

Livestock and meat

Cattle – feeder Chicago Mercantile Exchange 50,000 lb

Cattle – live Chicago Mercantile Exchange 40,000 lb

Pork bellies Chicago Mercantile Exchange 40,000 lb

Food and fibre

Cocoa New York Board of Trade 10 metric tons

Coffee New York Board of Trade 37,500 lb

closing futures price

The price used to settle all

contracts at the end of each

day’s trading. Also called the

settlement price or settle price

settle price

The price used to settle all

contracts at the end of each

day’s trading. Also called

the closing futures price or

settlement price

settlement price

The price used to settle all

contracts at the end of each

day’s trading. Also called the

closing futures price or settle

price

open interest

The number of a given type

of futures contracts that are

currently outstanding

futures contract
Involves two parties agreeing
today on a price at which the
purchaser will buy a given
amount of a commodity or
financial instrument from the
seller at a fixed date in the
future

opening futures price
The price on the first trade of
the day