Finance School of Management Forward Contract vs Spot Contract Price Delivery selfix To enter To exchange the into the asset(delivery) contract (quantit y, price and Tie future T dateypot contract is an agreement to buy or sel uesTc an asset immediately 6
6 Finance School of Management To enter into the contract (quantit y, price and future date) Delivery price(fixed) T To exchange the asset (delivery) A spot contract is an agreement to buy or sell an asset immediately Time Price 0
Finance School of Management Illustration a farmer a baker A farmer has planted her fields a baker will need wheat a with wheat and the size of her month from now to produce crop is reasonably certain bread It is now a month before A large fraction of his wealth is harvest tied up in his bakery business a large fraction of her wealth is The way for him to reduce the tied up in her wheat crop price risk is to buy wheat She want to eliminate the risk wheat now for future delivery associated with uncertainty The baker is a natural match about its future price by selling for the farmer to enter into a it now at a fixed price for forward contract future delivery uesTc
7 Finance School of Management Illustration: a Farmer & a Baker v A farmer has planted her fields with wheat, and the size of her crop is reasonably certain v It is now a month before harvest v A large fraction of her wealth is tied up in her wheat crop v She want to eliminate the risk associated with uncertainty about its future price by selling it now at a fixed price for future delivery v A baker will need wheat a month from now to produce bread v A large fraction of his wealth is tied up in his bakery business v The way for him to reduce the price risk is to buy wheat wheat now for future delivery v The baker is a natural match for the farmer to enter into a forward contract
Finance School of Management Illustration a farmer a baker Suppose the size of thethe farmers wheat crop is 100.000 bushels The forward price is $2 per bushel at the end of the month the farmer will deliver 100.000 bushels wheat to the baker and receive S200.000 from the baker in return Both parties eliminate the risk associated with the uncertainty about the spot price of wheat at the delivery date uesTc 8
8 Finance School of Management Illustration: a Farmer & a Baker v Suppose the size of the the farmer’s wheat crop is 100,000 bushels v The forward price is $2 per bushel v At the end of the month, the farmer will deliver 100,000 bushels wheat to the baker and receive $200,000 from the baker in return v Both parties eliminate the risk associated with the uncertainty about the spot price of wheat at the delivery date
Finance School of Management The difficulties to match a farmer and a baker The farmer and the baker may be separated by a great distant The farmer is located in Kansas and usually sells her wheat to a local distributor in Kansas The baker is located in New York, and usually buys wheat from a local supplier in New York e The exactly matched quantity The credit risk uesTc
9 Finance School of Management The Difficulties to Match a Farmer and a Baker v The farmer and the baker may be separated by a great distant – The farmer is located in Kansas, and usually sells her wheat to a local distributor in Kansas – The baker is located in New York, and usually buys wheat from a local supplier in New York v The exactly matched quantity v The credit risk
Finance School of Management Futures Contracts a standardized forward contract that is traded on an organized exchange Standardization of the terms of the future contracts (e.g. quantity, quality and delivery date The exchange interposes itself between the buyer and le seller as an intermediary The margin requirement and the mechanism of mark- to-market uesTc
10 Finance School of Management Futures Contracts v A standardized forward contract that is traded on an organized exchange – Standardization of the terms of the future contracts (e.g., quantity, quality and delivery date ) – The exchange interposes itself between the buyer and the seller as an intermediary – The margin requirement and the mechanism of ‘markto-market’