Module 2: Forwards and Futures Pricing and Hedging
1. Module Overview
This module explains how forwards and futures are priced and how they are used in hedging strategies. The focus is on understanding pricing logic, cost factors, and practical applications in managing financial risk.
2. Learning Objectives
By the end of this module, you will be able to:
- Understand how forward and futures prices are determined
- Identify key pricing factors such as interest rates and cost of carry
- Apply pricing logic to real-world scenarios
- Use forwards and futures effectively for hedging
3. Core Concepts
3.1 Forward vs Futures (Quick Distinction)
| Feature | Forward Contract | Futures Contract |
|---|---|---|
| Trading | Private (OTC) | Exchange-traded |
| Standardization | Custom | Standardized |
| Settlement | At maturity | Daily (mark-to-market) |
| Risk | Higher counterparty risk | Lower (clearing house) |
3.2 Pricing Logic (Intuition First)
The price of a forward or futures contract is based on:
- Current price of the asset (spot price)
- Interest rates (cost of money over time)
- Storage or holding costs (if applicable)
- Income from the asset (e.g., dividends)
Simple idea:
The futures/forward price reflects the cost of holding the asset over time.
4. Simple Pricing Diagram (Conceptual)
Today (Spot Price) -----> Future Date
Add:
+ Interest Cost
+ Storage Cost
Subtract:
- Income (if any)
= Forward/Futures Price
Meaning:
- Prices increase with carrying costs
- Prices decrease if the asset generates income
5. Hedging with Forwards and Futures
5.1 Long Hedge (Protect Against Rising Prices)
Used when you plan to buy in the future.
Future Buyer → Buy Futures Now
Example:
A food manufacturer locks in wheat prices today to avoid future price increases.
5.2 Short Hedge (Protect Against Falling Prices)
Used when you plan to sell in the future.
Future Seller → Sell Futures Now
Example:
A farmer locks in selling price before harvest.