Chapter 17
Futures Contracts
Copyright  2009 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-1
Learning Objectives
• Understand what a futures contract is and how
futures markets are organised.
• Understand the system of deposits, margins and
marking-to-market used by futures exchanges.
• Understanding the determinants of futures price.
• Understand that speculation and hedging with
futures contracts may be imperfect.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-2
Learning Objectives (cont.)
• Understand and explain the features of the major
financial futures contracts traded on the
Australian Securities Exchange (ASX).
• Explain speculation and hedging strategies
using the major financial futures contracts traded
on the ASX.
• Understand the valuation of 90-day bankaccepted bill futures contracts and share-price
index futures contracts.
• Understand and explain the uses of forward-rate
agreements (FRAs).
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-3
Futures and Forward Contracts
• A futures contract is an agreement that provides
that something will be sold in the future at a fixed
price.
• The price is decided today, but the transaction is
to occur later.
• Australian futures contracts are traded on the
Australian Securities Exchange (ASX).
• A forward contract will have the following features:
– The forward price is decided now, but the transaction is to
occur on a nominated future date.
– The details of the commodity, which are the subject of
the contract, are spelt out.
– The contract is a private contract between you and me.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-4
Characteristics of Futures
Market
• Standardised contract sizes and maturity dates.
• Clearing house guarantees performance of all
contracts, both buyers and sellers.
• Futures contracts require you to put up deposits and
satisfy margin calls if required.
• Buyers and sellers do not need to know the identity
or credit worthiness of other buyers and sellers.
• Note ‘short selling’ is possible.
• Contracts usually closed out (by taking offsetting
position) at or before maturity rather than physically
delivered.
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PPTs t/a Business Finance 10e by Peirson
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17-5
Deposits, Margin Calls and the
Mark-to-Market Rule
• Deposits
– All traders are required to open an account and
deposit a specified amount of money with the
clearing house before entering into first contract.
– Mark-to-market.
– The clearing house adjusts the recorded value of
an asset to its market price on a daily basis.
• Margin calls
– A requirement that extra funds be deposited as a
result of adverse price movements in the price of
a contract.
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PPTs t/a Business Finance 10e by Peirson
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17-6
The Australian Securities Exchange
(ASX)
• Opened for trading in 1960, was then called Sydney
Greasy Wool Futures Exchange — reflecting the
importance of the commodity (agricultural) futures at that
stage.
• ASX operates own clearing house to:
– Establish and collect deposits.
– Call in margins.
– Apportion the gains and losses.
• Some of the trading on the ASX include:
–
–
–
–
–
–
90-day bank-accepted bills.
3-year and 10-year Australian Treasury Bond.
Standard & Poors, ASX 200 (SPI200).
30-day inter-bank cash rate contract.
Australian dollar.
Options on futures contracts.
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17-7
Determinants of Futures Prices
• Futures pricing theorem
– The futures price for a late-delivery contract must be less
than (or equal to) the futures price for an equivalent earlydelivery contract, plus the carrying cost.
– The carrying cost is the cost of holding a commodity from
one time period to another.
 It includes an interest factor (opportunity cost of funds used
to finance the holding of the commodity) and, in the case of
physical commodities, the costs of insurance and storage.
– A futures price must be less than (or equal to) the current
spot price plus the carrying cost.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-8
Determinants of Futures Prices
(cont.)
Algebraically, it is written as:
where:
E  S   S  C  risk factor
F  futures price
S  current spot price
C  carrying cost
•
The maximum value that the expected spot price, E(S), can be,
given the current spot price, S, the carrying cost, C, and a risk
factor is given by:
F  S C
•
If there is a big difference between the expected spot price and
futures price, it may reflect an arbitrage opportunity, depending
on perceptions about the risk factor.
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PPTs t/a Business Finance 10e by Peirson
Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-9
Futures Market Strategies:
Speculating and Hedging
• Speculator: someone who has traded in a futures
contract but who has no direct interest in the
‘commodity’ underlying the futures contract.
– Affected by the futures price (but not the spot price) of the
commodity.
– By trading in futures contracts, speculators are exposed to
the risks of changes in the futures price — a risk to which
they would not otherwise have been exposed.
• Speculation — case study:
– Barings Bank — futures speculation gone wrong.
– Soceite Generale — allegedly unauthorised trading.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-10
Futures Market Strategies:
Speculating and Hedging
(cont.)
• Hedger: someone who has traded in a futures contract
and has a ‘genuine’ interest in the ‘commodity’
underlying the futures contract.
– Affected by both the futures price and the spot price of
the commodity.
– The hedger is exposed to the risk of changes in the
futures price, but only in an attempt to offset the preexisting risk of changes in the commodity price itself.
• Hedging — case study:
– Metallgesellschaft — case apparent hedging strategy
that went terribly wrong.
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-11
Speculating
• In the simplest case, a speculator hopes to:
– Take a long position (i.e. buy) when the futures price is
‘low’, reversing out (i.e. selling later) when the futures
price has increased; and/or
– Take a short position (i.e. sell) when the futures price is
‘high’, reversing out (i.e. buying later) when the futures
price has decreased.
• In either case, the speculator gains. However, if
the opposite occurs, the speculator loses.
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17-12
Speculating (cont.)
• Scalping:
– Scalpers try to develop a continuously updated
‘feel’ for the market, anticipating and exploiting
perceived short-term excesses of supply or
demand.
• Spreading:
– A ‘spread’ is a long (bought) position in one
maturity date, paired with a short (sold) position
in another maturity date.
• Day trading:
– Day traders are prepared to trade as they see
fit during a trading day, but regard an overnight
position as too risky.
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17-13
Speculating (cont.)
• Long-term/overnight position taking:
– The simplest and riskiest type of speculation.
– Speculators form a view that the current futures
price is too low (or too high), trade accordingly, and
wait for events to prove them right.
• Straddling:
– A ‘straddle’ is similar in concept to a spread but
refers to positions in futures contracts on different
commodities.
– For example:
 A speculator might buy a March bank bill contract
and sell a March bond contract.
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17-14
Hedging
• Example
– A grazier intends to sell his cattle in several
months’ time.
– He is affected by movements in the spot
price of cattle:
 Gaining if it increases (his cattle become
more valuable).
 Losing if it decreases (his cattle become less
valuable).
– To be protected against these changes, he
can sell cattle futures, that is, he becomes a
short hedger.
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17-15
Hedging (cont.)
• Short hedger
–
Someone who hedges by means of selling futures
contracts today (going short).
Table 17.3
Short hedging outcomes
IF PRICES RISE
IF PRICES FALL
Short futures contract
Loss
Gain
Cattle - spot
Gain
Loss
Net result
Approximately zero Approximately zero
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-16
Hedging (cont.)
• Long hedger
–
Someone who hedges by means of buying futures
contracts today (going long).
Table 17.4
Long hedging outcomes
IF PRICES RISE
IF PRICES FALL
Long futures contract
Gain
Loss
Cattle - spot
Loss
Gain
Approximately zero
Approximately zero
Net result
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Slides prepared by Farida Akhtar and Barry Oliver, Australian National University
17-17
Some Reasons Why Hedging
with Futures is Imperfect
• Imperfect convergence
– The price of a futures contract with zero time to maturity
ought to be equal to the spot price.
– However, in reality the futures price at maturity can be
slightly different from the spot price. The convergence
between the spot and futures price as the maturity date
approaches can be imperfect.
– Although this convergence will be imperfect, it may
not be possible to profit from this difference due to
transaction costs.
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17-18
Some Reasons Why Hedging
with Futures is Imperfect
(cont.)
• Basis risk
– A hedger will plan to transact in the spot market at some
future date. However, it is usual for the planned spot
transaction date to coincide with the maturity date.
– When the dates do not coincide, the hedger must reverse
out of the futures contract before it matures and faces
‘basis risk’.
– Basis: the spot price S at a point in time minus the
futures price F (for delivery at some later date) at that
point in time.
– At time zero the basis B is: B (0) = S (0) – F (0)
– At time 1 the basis B is:
B (1) = S (1) – F (1)
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17-19
Some Reasons Why Hedging
with Futures is Imperfect
(cont.)
•
Consider a short hedger: makes a gain (loss) on the futures contract
if the futures price decreases (increases), and a gain (loss) on holding
the commodity if the spot price increases (decreases).
Total gain to short hedger = gain made on futures
+ gain made on spot
 [ F (0) - F (1)]  [ S (1) - S (0)]
 [ S (1) - F (1)] - [ S (0) - F (0)]
 B (1) - B (0)
 change in basis between Time 0 and Time 1
•
Specification differences:
– Refers to the fact that the specification of the ‘commodity’ that is
the subject of the futures contract may not precisely correspond to
the specification of the ‘commodity’ that is of interest to a hedger.
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17-20
Selecting the Number of
Futures Contracts
• Suppose that a hedger has an interest in NS units of a
‘commodity’. If this interest is a long (short) position,
then NS is positive (negative).
• The optimum number of futures contracts f * is:
f
*
N s S0

N f F0
where:
S0  spot price per unit when the hedge is entered(today)
F0  futures price per unit when the hedge is entered(today)
N f  number of units of the commodity covered by each futures contract
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17-21
The Bank Bill Futures Contract
• Contract specifications for 90-day bank-accepted
bills:
– Contract unit — 90-day bank-accepted bill with a face
value of $1m.
– Delivery months — Mar, June, Sept, and Dec up to
3 years out.
– Delivery day — first business day after last trading day.
– Quotations — 100 minus annual percentage yield to two
decimal places.
– Settlement — cash or physical settlement.
– Settlement date — the second Friday of the delivery
month.
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17-22
Hedging with Bank Bill Futures
• Annamay Ltd needs to borrow in 2 weeks’ time by
issuing a 90-day bank bill with a face value of $1m.
Currently, bank bill rate is 4.4%.
• Risk: that the bill rate would increase; therefore, the
company decided to protect itself by selling one
BAB futures contract at 95.78 (4.22%).
• Scenario
– During the next 2 weeks, the 90-day bill rate increased and
the bill was issued at 5.5%. At this date the BAB futures
contract was priced at 94.70 (5.3%).
– Question: What is the result of this course of action?
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17-23
Hedging with Bank Bill
Futures (cont.)
• Physical market
planned borrowing:
actual borrowing:
1m
= $989267.13
[1 + (90 x 0.044/365)]
1m
= $986619.81
[1 + (90 x 0.055/365)]
Dollar shortfall (gross) = $989267.13 - $986619.81
=$2647.32
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17-24
Hedging with 90-day Bank Bills
•
Futures market
sell 1 bank bill futures:
1m
=$989,701.68
[1 + (90 x 0.0422/365)]
to close futures position, buy 1 bank bill futures:
1m
=$987,100.09
[1 + (90 x 0.053/365)]
Result from futures = $2601.59 (gain)
Net dollar shortfall = $ 2647.32 - $2601.59
= $45.73
•
Hedge reduces shortfall from $2647.32 to $45.73
(a reduction of 98.3%).
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17-25
10-year Treasury Bond
Futures Contract
• Contract specification
– Contract unit — 10-year government bond with a face
value of $100 000 and a coupon rate of 6% p.a.
– Settled by cash, not delivery.
– Quotations — 100 minus the annual percentage yield.
• Uses
– Can be used in ways similar to those explained for the
bank bill contract.
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17-26
The 30-day Interbank Cash
Rate Futures Contract
• The 30-day interbank cash rate futures contract is
similar to bank bill contract, which is suitable for
speculation, hedging and arbitrage in short-term
interest rates.
• Major features of 30-day interbank cash rate
futures contract include:
– Contract Unit.
– Settlement.
– Quotations.
– Termination of Trading.
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17-27
Share Price Index (SPI 200)
Futures Contract
• Specifications
– Contract unit: value of the S&P/ASX 200 Index,
multiplied by $25.
– Settlement: not deliverable, closed out at the close
of trading at the relevant spot index value, calculated
to one decimal place.
– Quoted as the value of the S&P/ASX 200 Index
(to one full index point).
• Example 17.13
– On 23 January 2008, the S&P/ASX 200 Index closed
at 5412.3 and the March (2008) SPI200 futures price
was $5379.
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17-28
Speculation with the SPI
Futures (cont.)
– Suppose that a speculator believes that share prices
are likely to rise in the following 2 weeks and, therefore,
decides to buy March SPI200 futures.
– On 30 January 2008, the S&P/ASX 200 Index has risen to
5618.7, and the March SPI futures price has risen to
$5589.
• The total gain can be calculated as follows:
Notional sale at:
5379 x $25 = $134 45 (outflow)
Notional purchase at: 5589 x $25 = $139 725 (inflow)
Gain (net inflow):
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$5 250
_
17-29
Hedging with SPI Futures
• Example 17.14
– Michael Saint manages a portfolio of Australian
shares with a current market value of $1 510 700.
– The portfolio is to be sold in 4 weeks’ time.
– The SPI 200 futures price today is 5421.
– Assume that proportionate changes in the portfolio’s
value will be matched by proportionate changes in
the futures price.
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17-30
Hedging with SPI Futures
(cont.)
Number of futures contracts needed to hedge the
portfolio:
NS
f  s 0
Nf 0
F
value of spot

position
value
of one futures contract
$1 510 7000


5421X$25
 111.47
  111
*
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17-31
Hedging with SPI Futures
(cont.)
Table 17.11
DATE
SPI FUTURES PRICE
PER CONTRACT
(INDEX FORM)
SPI FUTURES PRICE
FOR 28 CONTRACTS
($)
PORTFOLIO
VALUE
($)
When hedge entered
5421 (sold)
15 043 275
15 107 000
5159 (bought)
14 316 225
14 444 500
727 050
(662 500)
When hedge lifted
Gain (loss)
Therefore, the hedge has, in fact, resulted in a net gain of:
$727 050 – $662 500 = $64 550
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17-32
Valuation of Financial Futures
Contracts
• A restriction on the valuation of futures contract is
given by:
F  S C
where:
F  futures price
S  current spot price
C  carrying cost
• If the commodity can readily be sold short, and if
the opportunity cost of investment is the only form
of carrying cost, then:
F  S C
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17-33
Valuation of Bank Bill & SPI
Futures Contracts
• The bank bill futures price is simply the spot price of the
relevant bank bill, accumulated at the yield applicable to the
term of the futures contract.
F  S 1  it 

The valuation of the SPI futures contract is slightly more
complex, because dividends are paid on many shares in the
index but the calculation of the SPI excludes dividends.
F   S  PV  D  1  r 
where:
PV  D   present value of the dividends
F  futures price
S  current spot price
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17-34
Forward-Rate Agreements
(FRAs)
• An agreement to pay or receive a sum of money
representing an interest differential, such that the
interest rate applicable to a specified period is
fixed.
• Typically a private arrangement that cannot be
traded on a secondary market.
• Usually, at least one of the parties to an FRA will
be a bank or some other financial institution.
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17-35
Example of an FRA
• Company A intends to borrow $1m in 3 months, to
be repaid in a lump sum 180 days later.
• Present interest rate on 180-day loan is 9.4%.
• Company A approaches Bank B to set up a forward
rate agreement.
• Bank B does this at 9.5%.
• At the FRA settlement date the market interest rate
is 10.25%.
• Settlement amount is the difference between the
present value of $1m discounted at the contract rate
and the present value of $1m discounted at the
current market rate (differential: $3363.11).
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17-36
Summary
• Futures: Obligation to deliver/receive a physical or
financial commodity at a future date.
• Futures markets are based on a clearing house,
system of deposits, marking to market and margin
calls.
• Futures prices depend on the spot price, carrying
costs and cost of uncertainty or the risk factor.
• Futures can be used for hedging or for speculation.
However, it may not provide perfect hedging or
speculative features: basis risk, specification
differences and imperfect convergence.
• Forward-rate agreements are similar to futures and
offer an alternative means of risk management when
futures do not exist.
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17-37