01 fm&i chap 8 futures mkt

Chapter 8: Financial Futures

Markets

anticipated stock price movements

■ describe the different types of risk to which traders in financial futures contracts are exposed

⚫Derivatives are financial contracts whose

valued are derived from the values of

underlying assets

⚫Derivatives are widely used to speculate on future expectations or to hedge against a

security portfolio’s risk

⚫Derivative security prices related to factors affecting prices in the spot market

 For example, bond futures prices are related to what is happening in markets where bonds are bought and sold for immediate delivery

Forward Contract

⚫A forward contract or simply a forward is

a non-standardized contract between two parties to buy or sell an asset at a

specified future time at a price agreed

today

⚫A forward is in contrast to a spot contract, which is an agreement to buy or sell an

asset today

Forward Contract

⚫Advantages: Flexible since two parties agree upon types of securities, amount, price, delivery date

Background on Financial Futures

⚫ Future is a standardized agreement to deliver or take delivery of a financial

instrument at a specified price and date

⚫Price is determined by traders for

standardized contracts

 The underlying financial instrument

 Settlement date

 Form of delivery for underlying asset

⚫Trading on organized exchanges provides liquidity and guaranteed settlement

Example of Financial Futures

Background on Financial Futures

Popular Futures Contracts

⚫ Interest Rate Futures: Many of the popular financial futures contracts are on debt securities such as

Treasury bills, Treasury notes, Treasury bonds, and Eurodollar CDs These contracts are referred to as

interest rate futures For each type of contract, the

settlement dates at which delivery would occur are in March, June, September, and December.

⚫ Stock Index Futures There are also financial futures contracts on stock indexes, which are referred to as stock index futures A stock index futures contract

allows for the buying and selling of a stock index for a specified price at a specified date.

Background on Financial Futures

⚫ Most financial futures contracts in the U.S trade

through the CME Group, formed in July 2007 by the merger of the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME).

⚫ Only members or those leasing privileges can place orders in the exchange

 Commission brokers: Execute orders for their

Steps Involved in Trading Futures

⚫Establish account and initial margin

(5-18%) at brokerage firms

⚫Place orders (market or limit order)

⚫Maintenance margin and margin call

⚫Clearinghouse function: Recording all

transactions, guaranteeing timely

payments, supervising the delivery of the contracts

⚫Daily marked-to-market of contracts:

Recording profits or losses daily

Marked to Market

⚫ Profits or losses recorded for long position of 01

contract is as follows:

Day Profit (Loss) per ounce x 5.000 ounce/contract = Profit

(loss) per contract

Purpose of Trading Financial Futures

⚫ Financial futures are traded to speculate on prices

of securities or to hedge existing exposure.

⚫ Speculators in financial futures markets take

positions to profit from expected changes in the

futures prices.

Day traders attempt to capitalize on price

movements during a single day.

Position traders maintain their futures

positions for longer periods of time.

⚫ Hedgers take positions in financial futures to

reduce their exposure to future movements in

interest rates or stock prices

Institutional Use of Futures Markets

Interest Rate Futures Contracts

⚫ Interest rate futures contracts specify a face

value of the underlying securities, a maturity of the underlying securities, and the settlement

date when delivery would occur

⚫ There is a minimum price fluctuation for each

contract.

⚫ The price of an interest rate futures contract

reflects the expected price of the underlying

security on the settlement date.

⚫ Participants in the Treasury bond futures market monitor the economic and inflation indicators

that affect Treasury bond prices

Interest Rate Futures Contracts

Speculating with Interest Rate Futures

⚫ Long position; purchase futures contracts

⚫ Strategy to use if speculator anticipates interest rates will decrease and bond prices will increase

⚫ Buy a futures contract and if rates drop the

contract’s price rises above what it cost to

purchase and exchange adds gain with daily

settlement to investor’s account

⚫ If interest rates rise instead of fall, futures

contract price drops and investor’s account is reduced by daily loss

Exhibit 13.4 Potential Payoff From

Speculative Futures Position

Profit or Loss from Selling

a Futures Contract

Market Value

of the Futures Contract

as of the Settlement Date

S 0

of the Futures Contract

as of the Settlement Date

S 0

Speculating with Interest Rate Futures

⚫Short position; sell futures contracts

⚫Strategy to use if speculator anticipates

interest rates will rise and contract prices

received for the initial sale of the contract

⚫Speculator loses money if rates drop

Speculating with Interest Rate Futures

Impact of Leverage

⚫Since investors commonly use a margin account to take future positions, the return from speculating in interest rate futures is magnified substantially

Closing out the Futures Position

⚫ Most buyers and sellers of futures contracts do not actually make or take delivery of the underlying

asset

⚫ Can close position any time before contract

expiration date

⚫ Offset or close out their positions in the futures

market by the settlement date

⚫ Trade the same contract and maturity month but in opposite direction to open and close the position (buy before – sell now; sell before – buy now)

⚫ Obligations net out when traders close

Closing out the Futures Position

⚫Examples

 Open with the sale of a June maturity T-bill,

close with the purchase of a June maturity T-bill

 Open with the purchase of a June maturity bill and close with the sale of the same kind of contract and maturity June T-bill

T-⚫Gain or loss on a position depends on

purchase price compared to the selling

price

⚫Daily settlement with exchange

Hedging with Interest Rate Futures

⚫Using interest rate futures to create a short hedge

⚫Hedger adversely affected by an interest rate increase

 Bank using primarily short-term funds

to finance longer-term assets

Hurt by rising rates; must refinance

funding before investment re-priced

Hedging with Interest Rate Futures

⚫The short hedge

⚫Sell futures contracts with characteristics similar to the securities being hedged

⚫If rates increase, hedger closes out the

position at a profit in the futures market to offset spot market position opportunity loss (reduced interest margin)

⚫If rates decrease, hedger’s spot market

gains (wider interest margin) offset by

losses on the futures position

Short hedge

Charlotte Insurance Company plans to satisfy

cash needs in six months by selling its Treasury bond holdings for $5 million at that time It is

concerned that interest rates might increase over the next three months, which would reduce the market value of the bonds by the time they are sold To hedge against this possibility, Charlotte plans to sell Treasury bond futures It sells 50

Treasury bond futures contracts with a par value

of $5 million ($100,000 per contract) for 98-16

(i.e., 9816/32 percent of par value)

Short hedge

 T-bond future contract’s price delivered in 3/201X

is 103.91$ (for 100$ face value)

◼ The investor worries that bond price may reduce-> sell 02 future contracts

Short hedge

T-Bond price in 3/201X

102.91 103.91 104.91 Bonds’ value

Hedging with Interest Rate Futures

⚫Trade-off from using a short hedge:

 Interest rate rises – do not suffer from a decline

Hedging with Interest Rate Futures

⚫ Using interest rate futures to create a long

 Bank finances loans whose rates adjust every six

months with CDs that have a two-year term—long

futures position locks in loan rates to maintain spread

⚫ Hedger uses futures position to offset spot losses and gains—locks in a price or spread

Cross Hedge

⚫Hedge the interest rate risk of assets that cannot be perfectly matched by interest future contracts

⚫The effectiveness of the hedge depends

on the degree of correlation between the market values of the two financial

instruments

Stock Index Futures

⚫ The purchase of a stock index futures contract

obligates the purchaser to purchase the index at a specified settlement date for a specified amount.

⚫ Stock index futures contracts have settlement

dates on the third Friday in March, June,

September, and December.

⚫ The securities underlying the stock index futures contracts are not actually deliverable, so

settlement occurs through a cash payment.

⚫ Like other financial futures contracts, stock index futures can be closed out before the settlement

date by taking an offsetting position.

Background on Financial Futures

Stock Index Futures Contracts

Stock Index Futures

Valuing Stock Index Futures

⚫ The value of a stock index futures contract is highly correlated with the value of the underlying stock

index.

⚫ Changes in financial futures prices are primarily

attributed to changes in the values of the underlying securities (or indexes).

⚫ Indicators of Stock Index Futures Prices – The economic indicators that signal changes in bond

futures prices can also affect stock futures prices, but not necessarily in the same manner.

Stock Index Futures

Speculating in Stock Index Futures

⚫Stock index futures can be traded to

capitalize on expectations about general

stock market movements

⚫Speculators who expect the stock market to perform well before the settlement date may consider purchasing S&P 500 index futures

⚫Participants who expect the stock market to perform poorly before the settlement date

may consider selling S&P 500 index futures

Stock Index Futures

Hedging with Stock Index Futures

⚫Stock index futures are used to hedge the market risk of an existing stock portfolio

⚫Test of Suitability of Stock Index

Futures - The suitability of stock index

futures can be measured by the sensitivity

of the portfolio’s performance to market

movements over a period prior to taking a hedge position

Stock Index Futures

⚫A portfolio manager has a stock portfolio

valued at $400,000 In addition, assume

the S&P500 index futures contracts are

available for a settlement date one month from now at a level of 1600, which is about equal to today’s index value The manager could sell S&P 500 futures contracts to

hedge the stock portfolio Because the

futures contract is valued at $250 times

the index level, the contract will result in a payment of $400,000 at settlement date

Stock Index Futures

⚫At settlement date, S&P500 reduces 5% to 1520: Value of portfolio also reduces 5% = 400,000x95% = 380,000 but the future

contract results in a gain of 20,000 1520)x250) => total value is still 400,000

((1600-⚫ At settlement date, S&P500 increases

10% to 1760: Value of portfolio also

increases 10% = 400,000x110% =

440,000 but the future contract results in a loss of 40,000 ((1600-1760)x250) => total value is still 400,000

Stock Index Futures

⚫ Hedging issues

 Hedge is more effective if investor’s portfolio is diversified like the the underlying index for the futures contract

 Portfolio managers do not necessarily hedge the entire portfolio

⚫ Dynamic asset allocation with stock index futures

 Portfolio manager uses stock index futures to vary risk/return position of portfolio without

restructuring existing stock portfolios

 An efficient risk management technique

Net Gain (on Stock Portfolio and Short Position in Stock Index Futures) for Different Degrees of

Hedging

Stock Index Futures

⚫The hedge is more effective if the portfolio

is widely diversified as the stock index

⚫The hedge can be partial

⚫The higher the proportion of the portfolio is hedged, the more the portfolio’s

performance is isolated from the market

fluctuations

Stock Index Futures

⚫Prices of stock index futures versus stocks

 Differ to some degree

 Index futures prices may be higher or lower

than the underlying index

 Stock index futures can more rapidly change as expectations change—investors watch as

indicator of market direction

 Differentials reduce hedging effectiveness

⚫Test of suitability of stock index futures

Single Stock Futures

⚫Agreements to buy or sell a specified number

of shares of a specified stock on a specified future date

⚫They are regulated by the Commodity

Futures Trading Commission and the

Securities and Exchange Commission

⚫Settlement dates are on the third Friday of

the delivery month on a quarterly basis

(March, June, September, and December) for the next five quarters as well as for the

nearest two months

Risk of Trading Futures Contracts

Market Risk

⚫Refers to fluctuations in the value of the

instrument as a result of market

conditions

Basis Risk

⚫The risk that the position being hedged by the futures contracts is not affected in the same manner as the instrument underlying the futures contract

⚫Applies only to those firms or individuals

who are using futures contracts to hedge

Risk of Trading Futures Contracts

Liquidity Risk

⚫Refers to potential price distortions due to

a lack of liquidity

Credit Risk

⚫The risk that a loss will occur because a

counterparty defaults on the contract

⚫This type of risk exists for over-the-counter transactions in which a firm or individual

relies on the creditworthiness of a

counterparty

Risk of Trading Futures Contracts

Prepayment Risk

⚫Refers to the possibility that the assets to

be hedged may be prepaid earlier than

their designated maturity

Operational Risk

⚫The risk of losses as a result of

inadequate management or controls