36. Options, Futures and Other Derivatives Ch5: Forward and Futures Prices Pt11

[@zackhoward1167]

Mark that's what I like about you as a teacher; your not just an academic, but you've been in the trenches and had your own $ at risk and can apply these concepts and theroies to real world examples.

[@friendofprogress903]

Lol I do not think I ever want to see the word 'NORMAL' in futures trading again. I think academics need to understand the principal nature of markets and appreciate the implications thereof before expressing an opinion about the future. Great video Sir, thank you.

[@hari02081025]

Hi Mark, Regarding the definition of Normal Contango and normal backwardation. The definition found in CFA Level 2 book is "When futures prices are lower than expected spot prices, the situation is called normal backwardation. When futures prices are higher than expected spot prices, it is called normal contango." But the definition shown in this video is quit opposite. Please have a look and let us know. Thanks.

[@MarkMeldrum]

+hari prasad My mistake - fixed now.

[@hari02081025]

+Mark Meldrum (̶◉͛‿◉̶)

[@OttoFazzl]

So normal normal backwardation is when future spot price is above the futures prices? If so, the video seems to not have been fixed...

[@judegonsalves88]

Hi Mark, Could you please help with the following question? I can't wrap my head around it .. Which of the following is not a difference between forward commitments and contingent claims? A) The payoffs of forward commitments are linearly related to the underlying, whereas the payoffs of contingent claims are nonlinearly related to the underlying. B) Forward commitments have a higher degree of leverage than contingent claims. C) The value of forward commitments at the start is zero, whereas the value of contingent claims at the start is greater than zero. Answer is B) As forward commitments involve no exchange of cash at the initiation, there will not be any degree of leverage.

[@MarkMeldrum]

Since both sides of a forward contract are obligated, as the underlying moves up and down so do the positions to the forward, penny for penny. That is a linear relationship. For a contingent commitment, an option, only one party is obligated, the other has a right. So the most the side with the right can lose is the option premium. That is a nonlinear relationship. That eliminates A. Options cost money to buy, forwards do not, that eliminates C.

[@FuZhixiang]

Hi Mark! As for delivery options, the text says ".. c>y, so that the benefit from holding the asset are less than the risk-free rate". Is this argument stated by comparing c-y in F0=S0*e^(c-y)T with r in F0=S0*e^(rT) where the latter has the cost of carry only amounts to risk-free interest rate? Moreover, I would like to ask whether the cost of carry in delivery month is included in F0 or not? Thank you!

[@MarkMeldrum]

+Fu Zhixiang (Midiz) Point 1 - yes. r is equivalent to c>y in both IF there is no convenience yield. r is the cost of carry in all cases. However, that cost can be reduced if there is a benefit to holding the asset (hence the convenience yield. Point 2 - the cost of carry is included in F0 up to the date of expiration of the futures contract. Thus, the cost of carry is always in F0. T in the power term makes it so.

[@FuZhixiang]

+Mark Meldrum I appreciate your prompt and helpful reply. Thank you!

[@lingfengwang1855]

Hi, professor. As long as E(St)> future price, it is normal backwardation, E(ST)< future price , it is normal contango? Your online video note is opposite from the video which make me confused about which one is right.

[@mehhakk23]

Hi Mark. I think Contango & normal backwardation is not part of Level 1 derivatives now. It is just for clearing concepts. Is that right?

[@GunaSekharDora]

Hi @Mark Meldrum. Thanks for such an amazing series of lectures. I didn't understand what you've said in between 4:37 and 5:00. Would you mind explaining me the same in detail? Thank you.

[@MarkMeldrum]

its just means the futures price and the spot price will converge in the future regardless of what the shape of the futures curve is today.

[@mj6637]

So, if I theorize that the risk free rate is understated and commodity prices are thereby overvalued, and observe today a futures market in contango with rising future prices but expect rates to rise to accurately reflect market conditions, or I expect normal backwardation, then I would short futures contracts since E(S(T))>F(o) thereby locking in the sale of said underlying asset at a higher futures price today than what I expect in the future? Theoretically, of course.

[@MarkMeldrum]

Unless you are talking about interest rate options, an expected change in rates is not a reason to buy or sell futures.

[@maxheithmar334]

So contango is when the futures price is above the expected future spot (so it would be the distance to the lower E in each graph), and backwardation is when the futures price is below the expected spot (so the distance between the curve and upper E)?

[@MarkMeldrum]

The common interpretation is that contango is an upward sloping futures curve and backwardation is a downward sloping futures curve.

[@mrinevitable124]

The convenience yield is given to the person who would receive delivery to compensate for the uncertainty of delivery or is it given to the holder of the commodity to part with the goods he is holding?

[@MarkMeldrum]

No. the convince yield is not a monetary thing. It is a safety or security feeling that has value. I hold on to something because it is convenient to do so.

[@syeedmohammeduzzalhossain5452]

❤️❤️❤️

[@saptarsheechatterjee9557]

hello.. i m thankful for all the videos.. one doubt.. if c-y is downward sloping.. then cost of carry is least at end of period.. but short position will also get least future price.. so why would short seller will settle at end of period?

[@MarkMeldrum]

I am not quite sure what you are asking. So, if you are asking why the short side would settle, they have no choice - its a legally binding contract. If you are asking why they would have entered the position to begin with, you are confusing the objective futures price with a subjective belief about what the future will be. The futures price is just a function of the cost to carry, not a prediction about what the actual price will be in the future.

[@saptarsheechatterjee9557]

sorry for being not clear on the doubt.. for a downward sloping cost of carry.. cost of carry is low at end of period.. but future price is also low than beginning of period.. so for short position they will get lower price @end of period than beginning of period.. is it not better to deliver @beginning of period? i think what i am thinking wrong is future price is variable whereas it is fixed on the date of inception. please correct where i am going wrong.

[@MarkMeldrum]

The future price is the price at contract inception. The short side was clearly ok with that price otherwise they would not have entered. If the seller is in the money - deliver. If not, wait.

[@saptarsheechatterjee9557]

got it.. thank you :)

[@annadoyen5403]

Hi Professor, in the book CFA Level I reading 59 Practice Problem #10 we are asked "If the net cost of carry is positive, then the price of the forward contract on the asset is most likely: A. Lower than if the net cost of carry was 0, B. The Same than if the net cost of carry was 0, C. Higher than if the net cost of carry was 0". I think the book assumes/defines net cost of carry as = [Sum (Income) - Sum (Storage Cost)]e^-rt. Is this the correct definition? But your definition of U was [Sum (Storage Cost) - Sum (Income)]e^-rt so technically in this problem U

[@MarkMeldrum]

A forward price is just a spot price carried to some future date. So, if the cost of carry is positive, the forward price must be higher than the spot price. So C.

[@annadoyen5403]

Hi Professor, But the CFA answer says A and this is their explanation: "A is correct. An asset’s forward price is increased by the future value of any costs and decreased by the future value of any benefits: F0(T) = S0(1 + r)T - (γ - θ)(1 + r)T. If the net cost of carry (benefits less costs) is positive, the forward price is lower than if the net cost of carry was zero."

[@MarkMeldrum]

I had to look at the question itself. I see the difference. They are defining the cost of carry being positive when the benefits > costs. It seems that when they use the term 'positive cost' they are actually referring to a benefit and when they use the term 'negative cost' they are actually referring to a cost. I just think that is stupid. This is the only source I know of that defines a positive cost as a benefit. The word cost has a meaning. When I buy something it has a positive cost. That does not mean I get paid at checkout - it means I pay!! Hence a cost is an outflow - not an inflow. Except in the CFA text. This kind of redefining common terms actually gets even worse at Level 2. So under the CFA definition of a cost actually being a benefit, then A is the answer - if you can keep that straight.

[@annadoyen5403]

Hi Professor, Yes okay that's what I thought, thank you for clarifying! They also use the convenience yield as part of the benefit so for them net cost of carry is the present value of dividend + convenience yield - storage costs. Anyway thank for the quick reply and for the amazing videos!

[@Mengadmire]

Thank you~