Forward and Swap Markets

When you’re first introduced to Finance, the focus is almost exclusively on what you can buy today: what is the price of stock ABC right now, and how can that price be determined? However there are two essential markets that are omitted despite playing a key role in the financial world: forward and swap markets. The goal of this report will be to provide an introduction to the mechanics of forward markets, using oil as the commodity of representative analysis. In the first part we will look at the mechanics of futures contracts that will pave the way for more complex analysis in the second part.

Forward and Futures markets are very similar and both concern the idea of buying an asset at some pre-decided time in the future. There are some technical differences that the reader can explore, but the purposes of this paper we are going to keep things simple and refer solely to Futures contracts. For example we are going to examine what is the price of buying oil in July, and how changes in that price can reflect market trends that may not be evident in simply the spot price.

Below is a table showing the Futures prices for Crude Oil: West Texas Intermediate (WTI) on June 1st, 2018 from cmegroup.com.

The table can be interpreted as follows: Last refers the price of the last contract that was traded; for example the price of the last contract to purchase oil in September was $65.47 per barrel. If one were to buy this contract they would be agreeing to buy oil at a rate of $65.47 per barrel in September. The Prior Settle is the price of the contracts sold the day before, and change reflects the difference in the price over the previous day: for delivery in July the price is $1.33 per barrel lower than the day before. Open, High, and Low refer to exactly what one would expect. Volume shows the number of contracts that have been transacted during the current trading session, and the Hi/Low limit shows the range of prices over the previous year. On will observe prices decreasing as we move further into the future. That phenomena is common to oil and will be analyzed further in the second installment of this analysis.

Unfortunately Futures contracts are not as simple as buying a stock or a bond, and there are some important clarifications the reader must acknowledge. When one buys a Futures contract, he is not purchasing only one unit of the asset, but rather a contract specified amount. This number is usually very high, by virtue of the fact that Futures contracts were originally developed for suppliers of the product who wanted to hedge against price changes in their production. In our oil example, each contract purchases 1,000 barrels of oil, so the total price of the contract would actually be 65.47*1,000=$65,470. At first glance one may think that number is absurdly high, and who would ever want to spend that amount of money to invest in oil?

A second important clarification pertains to how Futures contracts are settled and the amount of capital an investor must put forward to take a specific position. To take a position, an investor only needs to put forth an initial margin decided by the Futures exchange that is a certain percentage of the contract amount. That initial margin will then fluctuate based on price changes in the contract, and if the margin amount goes below a pre-specified value called the maintenance margin, then he will either have to close out his position or add more to his margin account to maintain the position. This is best illustrated with an example.

Let’s suppose we buy the contract on June 1st expiring in September, such that the contract of $65,470. The margin percentage will be decided once the investor makes the purchase, as it will fluctuate depending on many factors. Let’s suppose the initial margin is 10% such that the investor only needs $6,547 to invest in $65,470 of oil! Furthermore let’s suppose the maintenance margin is 5%, or $3,273.50. If the investor’s margin goes below that value, he will need to either close out the position, or add an amount such that he returns to his initial margin. An important note here is that changes are based on the price of oil for the Futures contract, not the spot price of oil. By changing the investor’s margin amounts based on contract price fluctuations, Futures are said to be “Marked to Market”.

Let’s suppose the next day the price of the contract drops one dollar from $65.47 to $64.47. Because the contract is multiplied by 1000, the change in our maintenance margin will be $1000. Now we have $5,547 in our margin account (6,547-1,000). Then let’s imagine that there are reports of massive oversupply and the price plunges four dollars to $60.47. The resulting change in our margin is $4000 dollars, and now we only have $1,547 dollars, which is well below the maintenance margin. So now the investor is faced with the decision of either closing out the contract, and suffering a major loss, or injecting capital into his maintenance margin to avoid losing the position. He would have to place an amount of money such that he returns to his initial margin amount, which in this case he would have to deposit $5000 dollars.

Let’s proceed assuming the investor deposits the $5,000 to maintain his position. The next key question is what will happen when the contract expires in September? Futures contracts can be settled through either cash or delivery. Cash settlement is easiest as it will simply result in a gain or loss depending on the difference between the futures contract originally bought and the value of the contract at settlement, which should be equal to the spot price at that day. If September comes around and the futures contract is worth $66.00, the investor will have made a profit of $.53 (66-65.47) *1000 = $530.

The total return on the investment will combine the profit made and the total amount of margin deposited throughout the life of the investment. Continuing with our example, we had to put 6,547 + 5,000= $11,547 total in our margin account (assuming no more margin calls). With a $530 profit, the total return is 4.59%.

However many assets are not cash settled, but rather delivered. Obviously an investor who simply wanted to speculate on oil will not want to receive 1000 barrels of oil (if the position was long) or deliver 1000 barrels (if the position was short). To resolve this issue of delivery, the investor can short the futures contract before the settlement period, causing the long and short positions to cancel out. For example if we were long for delivery in September, we could short a Futures contract late August to ensure that we did not have to take delivery. The short would have to be an equal offset in terms of contract size: If we are taking delivery of 1000 barrels, we must short a contract that will also deliver 1000 barrels.

To conclude the first part, we will look at a chart showing how futures prices for oil deliverable in September have changed over the past several months:

Futures prices will not equal the current spot price, but it is evident that futures prices follow approximately the same trend as spot prices: if the price of oil today increases it is likely the price of a contract expiring in September will also increase. Here we make the essential clarification: the price of a futures contract expiring at some time T is not the expected price of oil at time T. The determinants of futures prices will be examined in the second part, but it is necessary that one does not confuse the futures price with the price that the market expects oil to be at the given time. The run up in prices from March to May seen in the spot market translated well into the Futures Market, but investors who purchased during that run may not profit if prices fail to gain until September.

Now that we have gained an appreciation for how futures contracts work, we can look at more advanced topics that will help us merge what we see in the news regarding oil and the price fluctuations we see on a daily basis.