Citibank future market

In order to provide superior service to our customers,the CFC must: n Provide technical knowledge and market expertise essential to the development of effective hedging and trading stra

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TABLE OF CONTENTS

Introduction

Course Overview vCourse Objectives vThe Workbook vi

Unit 1: Fundamentals of Futures

Introduction 1-1Unit Objectives 1-1Development of Futures Contracts 1-1Forward Contracts 1-1The Need to Reduce Credit Risk 1-2Contract Characteristics 1-4Closing Out a Position 1-6Participation in the Futures Market 1-7Summary 1-7Progress Check 1 1-9

Unit 2: Futures Markets - The Key Players

Introduction 2-1Unit Objectives 2-1The Players 2-1Types of Traders 2-1

Speculators 2-1 Arbitragers 2-2 Locals 2-2 Hedgers 2-2

Participation in the Futures Market 2-3

Trading for Profit 2-3

Unit 3: Futures Market Prices

Introduction 3-1Unit Objectives 3-1Market Awareness 3-1Pricing 3-6The “Underlying” 3-6Futures Contract Price vs Cash Market Price 3-6Margin Payments 3-8Summary 3-9Progress Check 3 3-11

Unit 4: Interest-rate Futures

Introduction 4-1Unit Objectives 4-1Major Types of Interest-rate Futures Contracts 4-1Cash-settled Futures Contracts 4-2Deliverable Contract 4-3Using Interest-rate Futures to Hedge Interest-rate Risk 4-4Additional Considerations When Hedging

with Futures 4-6Who Should Use Futures for Hedging? 4-8Summary 4-10Progress Check 4 4-13

TABLE OF CONTENTS v

Unit 5: Currency Futures

Introduction 5-1Unit Objectives 5-1Currency Futures Contracts 5-1Contract Features 5-2Hedging with Currency Futures 5-4Summary 5-5Progress Check 5 5-9

Appendices

Appendix A: The Mechanics of Futures Markets A-1Appendix B: ISO Codes B-1Appendix C: Financial Derivatives Exchanges’ Websites C-1

Glossaries

English G-1Spanish G-5

Index

iv TABLE OF CONTENTS

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INTRODUCTION: FUTURES

COURSE OVERVIEW

In the first course of this workbook, Interest-Rate Forwards, you learned aboutForward Rate Agreements (FRAs), their structure, and the many ways that banks andtheir customers can benefit from their use You are now ready to move on to thiscourse on Futures

The major futures organization within Citicorp is the Citicorp Futures Corporation(CFC) The CFC provides brokerage to investment bank customers in interest rate,currency, and precious metals In order to provide superior service to our customers,the CFC must:

n Provide technical knowledge and market expertise essential to the

development of effective hedging and trading strategies

n Create new futures products such as stock index futures

n Participate in exchanges in many different countries

n Explain how and why futures contracts differ from forward agreementsMany units of Citicorp are major users of futures contracts They purchase and sellfutures contracts in order to hedge price risks resulting from customer business

In the five units of this workbook, you will be introduced to futures, including thebenefits of futures contracts, as well as the limitations of futures contracts

COURSE OBJECTIVES

When you complete this workbook, you will be able to:

n Describe a futures transaction

n Interpret a newspaper report of futures trading

n Explain how futures contracts differ from forward contracts

n Determine whether futures or forwards would be preferrable for a givencounterparty

viii INTRODUCTION

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THE WORKBOOK

This self-instruction workbook is designed to give you complete control over your

own learning The material is divided into workable sections, each containing

everything you need to master the content You can move through the workbook at

your own pace and go back to review ideas that you didn't completely understand thefirst time Each unit contains:

Unit Objectives – which point out important elements in the unit

that you are expected to learn

Text – which is the "heart" of the workbook This

section explains the content in detail

Key Terms – which also appear in the Glossary They

appear in bold face the first time they appear

in the text

Instructional Mapping –

terms or phrases in the left margin whichhighlight significant points in the lesson

þ Progress Checks – help you practice what you have learned andcheck your progress Appropriate questions

or problems are presented at the end of eachunit You will not be graded on these byanyone else; they are to help you evaluateyour progress Each set of questions isfollowed by an Answer Key

If you have an incorrect answer, we encourageyou to review the corresponding text, then trythe question again

In addition to these unit elements, the workbook includes the:

Appendices – which present related information for interested readers Glossary – which contains definitions of all key terms used in the

workbook

Index – which helps you locate the glossary item in the workbook

INTRODUCTION ix

Each unit covers some aspect of futures trading The units are:

n UNIT 1 – Fundamentals of Futures

n UNIT 2 – Futures Markets - The Key Players

n UNIT 3 – Futures Market Prices

n UNIT 4 – Interest-rate Futures

n UNIT 5 – Currency Futures

Since this is a self-instructional course, your progress will not be supervised Weexpect you to complete the course to the best of your ability and at your own speed.Now that you know what to expect, you are are ready to begin Please turn to Unit 1.Good Luck!

x INTRODUCTION

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UNIT 1: FUNDAMENTALS OF FUTURES

INTRODUCTION

Futures transactions have increased substantially in the past 20 years Futures andinterest-rate forwards share some common characteristics, but they differ in otherimportant ways In this unit, you will learn how futures contracts are structured andused, and how they differ from interest-rate forwards This unit will provide a

foundation for your study of futures markets in following units

When you complete this unit, you will be able to:

n Recognize the relationship between a futures contract and a

forward contract

n Identify the three requirements for creating a futures contract

n Recognize the alternatives available to buyers and sellers for

closing a position

Forward Contracts

Forward contracts have been used for centuries to facilitate

future delivery of many commodities around the world Thesecontracts are agreements which legally bind a party to buy orsell a specific quantity of a well-defined asset at a well-definedtime in the future The delivery of the asset can either be

specified for a particular date, or within a particular shortperiod of time In the past 20 years, the application of forwardcontracts has expanded to include financial instruments

Dual-collateralized

forward

contracts

Eventually, the question of performance was raised on both sides

of the transaction Of course, it made little sense for two parties

to hand each other the same amount of collateral,since a default on the agreement would involve a loss of thecollateral placed by the non-defaulting party as well The solutionwas to place the collateral with an intermediary, creating dual-collateralized forward contracts

Mitigate

price risk

The amount of the parties' collateral had to cover both the creditrisk and the financial risk (the price risk) of non-performance.With long-term agreements, this price risk could be quite large,and the collateral equally as large To reduce the amount of theinitial collateral deposit, long-term dual-collateralized

agreements called for periodic payments to cover price changesduring the agreement's term

Example For example, suppose that a three-year agreement states that if a

price movement occurs during any month, the adversely affectedparty will be required to make an additional collateral

contribution In this case, the initial collateral only has to coverthe price risk for one month, not the entire three years

called marking-to-market The amount of collateral which is

periodically modified according to the mark-to-market process

is called margin With more frequent marked-to-market

margining, less initial collateral is required

loser to the gainer, then performance risk is very low If the

third party holding the initial collateral adds a financialguarantee, it effectively removes the credit risk of thecounterparty and replaces it with a well-collateralized credit risk

reduced with two positions that offset each other.

Standard

agreements

To increase the likelihood that two agreements have the sameoffsetting price risk, standard agreements are written with thehelp of an intermediary In these agreements, the only

negotiable issue is the price; all other terms are defined Fromthe perspective of an intermediary holding the collateral, itdoesn't matter who the counterparty is Thus, offsettingpositions held by any one party are netted and removed from thebooks

If an intermediary is intimately involved in the writing of theagreements used, and then guarantees financial performance, itmight just as well become the offsetting counterparty to everytransaction For example, if Party A agrees to buy at a price of

90 from Party B, then the intermediary can just as easily agree

to buy at a price of 90 from Party B and sell at a price of 90 toParty A

1-4 FUNDAMENTALS OF FUTURES

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This third party is comprised of a futures exchange for

rule-making and trading, and a clearinghouse for settlement and

administrative duties The initial collateral is known as an

initial margin deposit.

contract, and a futures contract

A cash contract is similar to any sight purchase: delivery is

immediate in exchange for payment (according to normaldelivery procedures) The date of the delivery and payment is

often called the spot date.

A forward contract establishes an agreed-upon delivery date inthe future Payment is at delivery, or the agreement establishesthe parameters for determining a cash settlement on the futuredate

A futures contract is similar to a forward contract, except that

it is standardized, adds mark-to-market margining to reducecredit risk, and is established through an organized exchange

Forward

contract

elements

A basic forward contract contains the following information:

n Description of the underlying asset

n Delivery conditions (including dates)

n Price

n Payment conditions

n Conditions for endorsing to third parties

n Provision for handling exceptions

FUNDAMENTALS OF FUTURES 1-5

Additional future

contract

elements

Futures contracts have all the elements of forward contracts

and, additionally, have standardized:

on price Let's look at three examples:

Example 1 Yen Futures

Yen futures on the Chicago Mercantile Exchange (CME) specifythe delivery of 12.5 million yen on a single maturity date

Example 2 Treasury Bond Futures

U.S Treasury Bond futures traded at the Chicago Board of Trade(CBT) specify that the T-bonds to be delivered must have 20years to maturity with at least 15 years to

the first potential repayment date The CBT also supplies astandardized formula to adjust the actual cash paid for each bond

so that bonds of different maturities and coupon rates can becompared (“Coupon” refers to the interest payment

on the bond.) The standardized formula makes adjustments

to any bond which does not have an 8% coupon (6% coupon3/2000) Larger coupons are more valuable, and the amount paid

for those bonds is appropriately increased Bonds with coupons

below 8% are less valuable, and the amount paid for them is

decreased.

1-6 FUNDAMENTALS OF FUTURES

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Example 3 Eurodollar Futures

Eurodollar (ED) futures at the Chicago Mercantile Exchange(CME) mature on the second London business day before the thirdWednesday of the month On that day, the CME uses actual banklending rates for three-months (LIBOR) to settle the contract Thefinal contract settlement price is 100.00 minus 3 month LIBOR

(expressed as a percent) The higher the level of LIBOR at finalsettlement, the lower the price of the ED future

Establishing

price

The price of a futures contract is established through free-marketbidding and offering The marketplace may consist of individualslinked through telecommunications and computers, or it may be

an actual physical location where potential counterparties see andhear each other The process of bidding and offering in the

physical marketplace is called

open outcry.

Closing Out a Position

Two alternatives Buyers and sellers of futures contracts have two alternatives

available for closing out a position

1) The buyer can accept (or the seller can deliver), the

asset on the date specified in the contract, unless the

contract is cash settled, in which case the final margin

payment closes the position

2) The buyer and seller can offset their positions prior

to delivery date

Offsetting Most futures contracts are offset before the delivery date;

buyers seldom take possession of the asset — and sellersseldom deliver the asset

n Buyers (holders of a long position) offset by selling an

identical contract for the same delivery month Holding

a long position means they profit if the futures price of

the underlying asset increases.

FUNDAMENTALS OF FUTURES 1-7

n Sellers (holders of a short position) offset by buying

an identical contract for the same delivery month

Holding a short position means they profit if the futures

price of the underlying asset decreases.

In other words, either the buyer or seller can offset a position

with another transaction that is opposite (buyers sell and sellers buy) and equal (identical contract and amount).

Participation in the Futures Market

Standardization

increases liquidity

The standardization of contract terms helps to increase theliquidity (volume of trading) in individual futures contractsbecause parties with similar, though different, positions choosethe same futures contract The strict margining process removes

credit risk, which allows for greater participation in the futures market than in the traditional forward market In addition to the

large banks and multi-national corporations that use forwardcontracts, small companies and individuals that usually cannot useforward contracts can easily participate in the futures market

SUMMARY

In this unit, we focused on the differences between a forwardcontract and a futures contract

A forward contract is a legally binding commitment to buy or

sell — or affect the financial equivalent of buying or selling:

n A specified quantity of an underlying asset

n On a specified future dateAll forward contracts must contain at least the following basicinformation:

n Description of the underlying asset

n Delivery conditions (including dates)

n Conditions for endorsing to third parties

n Provision for handling exceptions

A futures contract has all the elements of a forward contract Inaddition, it is standardized, reduces credit risk with mark-to-market margining, and is established through an organizedexchange

A futures contract is usually closed out with offsettingtransactions by both parties before the specified future date.Standardization and the reduction in credit risk due to mark-to-market margining allow for greater diversity of participation in

the futures market than in the forward market.

You have now completed Unit 1: Fundamentals of Futures Please answer the

questions in the following Progress Check before continuing to the next unit,

Futures Markets – The Key Players If you answer any question incorrectly, you

should return to the text and read that section again

FUNDAMENTALS OF FUTURES 1-9

Directions: Complete the multiple choice questions by checking the correct

answer(s) Compare your answers with the Answer Key on thefollowing page

Question 1: Which definition best describes a futures contract?

_ a) Agreement to buy an asset on a designated future date, at a floating

rate _ b) Standardized contract to buy or sell an asset at a specified price, at

some unspecified future time _ c) Standardized contract to buy or sell an asset at a specified price on

a specific future date _ d) Agreement to sell an asset in the cash market, at a specified price

Question 2: The characteristics that differentiate a futures contract from a forward

contract are:

_ a) agreed-upon delivery date, mark-to-market margining, and

parameters for determining cash settlement

_ b) standardization, mark-to-market margining, and establishment

through an organized exchange

_ c) immediate delivery in exchange for payment, mark-to-market

margining, and standardization

_ d) payment at delivery, standardization, and establishment through an

organized exchange

Question 3: Which statement best describes payment conditions for futures

contracts?

_ a) Futures contracts are usually canceled before delivery date;

therefore, no money is paid

_ b) Seller pays an initial margin deposit to assure the buyer that s/he

can deliver on the futures contract

_ c) Buyer pays an initial margin deposit to assure the seller that s/he

will take delivery of the asset

_ d) The seller and the buyer pay initial margin deposits to show they

are both able to fulfill the contract

1-10 FUNDAMENTALS OF FUTURES

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ANSWER KEY

Question 1: Which definition best describes a futures contract?

c) Standardized contract to buy or sell an asset at a specified price on a specific future date

Question 2: The characteristics that differentiate a futures contract from a forward

FUNDAMENTALS OF FUTURES 1-11

PROGRESS CHECK 1

(Continued)

Question 4: What does it mean to offset a futures contract?

_ a) Before the delivery date, another transaction is concluded with an

identical but opposite futures contract

_ b) Futures contracts are bought by another party

_ c) Delivery of the underlying financial instrument takes place one

week before the specified date

_ d) Before the delivery date, another transaction is concluded which is

exactly the same

Question 5: Select two alternatives that futures buyers have for closing out their

position

_ a) They can offset their position by buying an identical contract for

the same delivery month

_ b) They can offset their position by selling an identical contract for

the same delivery month

_ c) They can take delivery of the assets

_ d) They can deliver the assets

Question 6: Indicate two alternatives that futures sellers have for closing out their

position

_ a) They can offset their position by buying an identical contract for

the same delivery month

_ b) They can offset their position by selling an identical contract for

the same delivery month

_ c) They can take delivery of the assets

_ d) They can deliver the assets

1-12 FUNDAMENTALS OF FUTURES

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ANSWER KEY

Question 4: What does it mean to offset a futures contract?

a) Before the delivery date, another transaction is concluded with an identical but opposite futures contract.

Question 5: Select two alternatives that futures buyers have for closing out their

position

b) They can offset their position by selling an identical contract for the same delivery month.

c) They can take delivery of the assets.

Question 6: Indicate two alternatives that futures sellers have for closing out their

UNIT 2: FUTURES MARKETS – THE KEY PLAYERS

INTRODUCTION

Now that you are familiar with the fundamentals of futures, let's see how the futuresmarkets operate Why do traders engage in futures transactions? How

do corporations use futures to improve and safeguard their assets? These two

questions will be answered in this unit In addition, you'll learn how hedging is

used to reduce risk

UNIT OBJECTIVES

When you complete this unit, you will be able to:

n Identify and describe three motives for engaging in a futures transaction

n Recognize how futures can be used to enhance and protect corporateresults

Types of Traders

Futures markets offer opportunities for four types of traders:

speculators, arbitragers, locals, and hedgers.

Speculators

Profit

opportunity with

risk

A trader who engages in speculation enters into a transaction

because it offers the opportunity for a large profit At the sametime, however, it offers the possibility of a big loss

2-2 FUTURES MARKETS – THE KEY PLAYERS

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Speculators trade futures to gain leverage, which is the potential

for profit without substantial capital commitment For a margin

deposit of 10%, an unanticipated 5% increase in the futures market results in a return on capital of 50% (less transaction

costs) Of course there is also the possibility that futures pricesmay decline and cause a loss for the trader

Arbitragers

Play one

market against

another

A trader who engages in arbitrage attempts to profit by

simultaneously purchasing and selling closely-relatedinstruments in different markets

Arbitragers play one market against another, looking for aproduct that is overvalued in one market relative to the other.They buy where it is undervalued, sell where it is overvalued,and make a profit if the differential exceeds transaction andcarrying costs (the cost of arbitrage)

Locals

Locals are traders working on the floor of an exchange whoengage in speculation and arbitrage for their own accounts.Local traders hope to profit from the minute-by-minute flow offutures transactions

Hedgers

Offsetting risk

in current

position

Hedging is the purchase or sale of financial instruments with the

objective of protecting overall results by offsetting the riskinherent in a current position This hedge may change a variable

rate to a fixed rate or the opposite It may "lock-in" or "fix" a loss,

or it may "lock-in" or "fix" a profit Hedging to lock-in a loss is

advisable when changes in market conditions are likely to result

in greater losses

In some hedging transactions, especially in the commoditiesmarkets, hedgers anticipate the future need for a product, act topreset a favorable price, guarantee supply or demand, andprotect themselves against possible losses They buy or sellfutures contracts that serve as substitutes for later positions in

a physical market in order to reduce risk

FUTURES MARKETS – THE KEY PLAYERS 2-3

Participation in the Futures Market

Traders participate in the futures market either to make a profit

n The speculator assumes a large amount of risk for thepossibility of equally large returns

n The arbitrager looks for market inefficiencies to make aprofit

You can say that speculators help launch markets — andarbitragers make them more efficient Both speculators andarbitragers add to the liquidity of the market

Trading to Reduce Risk

Hedgers In contrast, hedgers seek to reduce risk inherent in their business

by locking in returns on investments, fixing costs, andguaranteeing the future supply of currencies and commoditiesrequired for their operations

Corporations usually trade in the futures market as hedgers

Now that we have examined the four types of traders and theirmotives, let's move to the hedging strategies traders use toreduce risk

HEDGING STRATEGIES

Risk Reduction

Requires

knowledge

about the asset

The only motivation behind hedging is the reduction of risk.Therefore, hedging requires knowledge about the asset to bedelivered and the effect of economic forces on its future andcash markets

2-4 FUTURES MARKETS – THE KEY PLAYERS

2) A Japanese exporter of robots will receive USD 1,000,000

in six months She is worried that the U.S dollar mightfall in value against the Japanese yen She buys Japaneseyen futures contracts, agreeing to pay U.S dollars in thefuture and receive yen in the future This reduces the risk

of the U.S dollar falling in value and the yen rising invalue

3) A corporate treasurer expects floating (variable) interestrates to rise In order to hedge its floating-rate loan interestcost, the corporation sells Eurodollar futures (ED) Asshort-term interest rates rise, the price of the ED futureswill fall, and the corporation will receive profit from thefutures position This profit will be used to offset theadded interest cost on the loan

These strategies are especially successful if the futures marketprice is inconsistent with the decision-maker's belief

! direct, where the asset closely follows a trend, or

! inverse, where the asset moves in the oppositedirection

FUTURES MARKETS – THE KEY PLAYERS 2-5

Direct mimic Stock market index futures are direct mimics of overall

economic health If the economy is doing well, they tend tomove upward; if the economy is not doing well, they tend tomove downward

Inverse mimic However, when the economy deteriorates, people tend to hoard

gold which causes gold prices to rise This is an inverse mimic

of general economic trends because it is contrary to them.Businesses engage in hedging activities because they:

! Require specific quantities of certain assets

! Recognize that the spot and future prices of certainassets reflect economic realities

! Want to avoid riskTherefore, corporations primarily trade in the futures market

as a means of protecting and enhancing their businessactivities — not as a source of revenue

Hedging versus Speculating

If a party has no underlying (intrinsic) exposure to the factorswhich influence a futures contract, then establishing a

position with the futures contract is definitely speculation.

If a party has an underlying exposure and uses a futuresposition to reduce the business risk of that underlying

exposure, then the process is called hedging.

because the party expects the market conditions to change

unfavorably An example is selling yen in the futures market

due to the expected receipt of yen in the future and theexpectation of a weakening yen This selective hedging is

actually speculating, since the hedge is only taken based upon

the speculation that the yen will weaken True hedging must

be a consistent policy independent of expectations.

2-6 FUTURES MARKETS – THE KEY PLAYERS

Although speculators and arbitragers seek substantial returnsfrom their trading, they work in different ways While thespeculator takes large risks, the arbitrager relies oninefficiencies in the market

Hedgers, on the other hand, reduce risk by locking in returns ontheir investments, fixing costs, and guaranteeing a future supply

of currencies and commodities Corporations and banks oftentrade as hedgers

Traders hedge to reduce risk To be successful, they must haveknowledge of the asset to be delivered — and also know the effect

of economic forces on its future and cash markets Hedgingstrategies include locking in a current futures interest rate inanticipation of a drop in interest rates, and locking in a currentfutures price when a drop in the cash price is expected

You have now completed Unit 2: Futures Markets – The Key Players Please

complete the following Progress Check before continuing to the next unit, Futures

Market Prices If you answer any question incorrectly, you should return to the text

and read that section again

FUTURES MARKETS – THE KEY PLAYERS 2-7

Directions: Complete the questions below as directed Compare your answers

with the Answer Key on the following page

Question 1: Three reasons for trading futures are speculation, arbitrage, and

hedging Match each term to its definition

Speculation a) Offsetting a current or expected position

Arbitrage b) Engaging in risky transactions with the

expectation of a large profit Hedging c) Purchasing and selling closely related assets

in different markets at the same time

Select the one best answer in questions 2, 3, 4, 5, and 6.

Question 2: Why do speculators enter the futures market?

_ a) It is a very volatile market and requires substantial margin

investments

_ b) Low margin requirements practically guarantee a profit

_ c) The low margin requirements provide a great deal of leverage. _ d) It provides leverage that protects against losses

Question 3: The opportunity for arbitrage occurs when the difference between spot

prices and futures prices:

_ a) increases

_ b) differs from the "cost" of arbitrage

_ c) decreases

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ANSWER KEY

Question 1: Three reasons for trading futures are speculation, arbitrage, and

hedging Match each term to its definition

b Speculation a) Offsetting a current or expected position

c Arbitrage b) Engaging in risky transactions with the

expectation of a large profit

a Hedging c) Purchasing and selling closely related assets

in different markets at the same time

Question 2: Why do speculators enter the futures market?

c) The low margin requirements provide a great deal of leverage.

Question 3: The opportunity for arbitrage occurs when the difference between spot

prices and futures prices:

b) differs from the "cost" of arbitrage.