INTRODUCTION TO FINANCIAL
FUTURES MARKETS
CHAPTER 10
Emre Dülgeroğlu
Yasin Çöte
Rahmi Özdemir
Kaan Soğancı
• Our purpose in this chapter is to provide an
introduction to financial futures contracts,
how they are priced, and how they can be
used for hedging.
What a futures contract is?
• A futures contract is an agreement that requires a party to
the agreement either to buy or sell something at a designated
future date at a predetermined price.
• Futures contracts are categorized as either commodity
futures or financial futures. Commodity futures involve
traditional agricultural commodities (such as grain and
livestock), imported foodstuffs (such as coffee, cocoa, and
sugar), and industrial commodities. Futures contracts based
on a financial instrument or a financial index are known as
financial futures. Financial futures can be classified as
• (1) stock index futures
• (2) interest rate futures
• (3) currency futures.
who do you use futures contracts markets?
1. Hedgers
2. Speculators
3. Brokers
MECHANICS OF FUTURES TRADING
• A futures contract is a firm legal agreement between a buyer
and an established exchange or its clearinghouse in which the
buyer agrees to take delivery of something at a specified price
at the end of a designated period of time. The price at which
the parties agree to transact in the future is called the futures
price. The designated date at which the parties must transact
is called the settlement date.
LIQUIDATING A POSITION
• Most financial futures contracts have settlement dates in the
months of March, June, September, or December.
• The contract with the closest settlement date is called the
nearby futures contract.
• The contract farthest away in time from the settlement is
called the most distant futures contract.
• A party to a futures contract has two choices on liquidation of
the position.
First, the position can be liquidated prior to the
settlement date.
The alternative is to wait until the settlement date.
Clearinghouse
• A clearinghouse is agency associated with an exchange, which
settles trades and regulates delivery.
THE ROLE OF THE CLEARINGHOUSE
• Associated with every futures exchange is a clearinghouse,
which performs several functions, one of these functions is
• guaranteeing that the two parties to the transaction will
perform.
• Besides its guarantee function, the clearinghouse makes it
simple for parties to a futures contract to unwind their
positions prior to the settlement date.
MARGIN REQUIREMENTS
• When a position is first taken in a futures contract, the
investor must deposit a minimum dollar amount per contract
as specified by the exchange.
• Three kinds of margins specified by the exchange:
1) initial margin (may be an interest-bearing security
such as a Treasury bill, cash, or line of credit)
2) maintenance margin (specified by the exchange)
3) variation margin (additional margin to bring it back to
the initial margin if the equity falls below the maintenance
margin, must be in cash).
MARKET STRUCTURE
• On the exchange floor, each futures contract is traded at a
designated location in a polygonal or circular platform called a
pit. The price of a futures contract is determined by open
outcry of bids and offers in an auction market.
• Floor traders include two types: locals and floor brokers.
Daily Price Limits
• The exchange has the right to impose a limit on the daily price
movement of a futures contract from the previous session's
closing price.
FUTURES VERSUS FORWARD CONTRACTS
• A forward contract, just like a futures contract, is an
agreement for the future delivery of something at a specified
price at the end of a designated period of time.
Futures contracts
Forward contracts
Standardized contract
(delivery date,
quality, quantity)
yes
no
Where to be traded
(primary market)
organized exchanges
over-the-counter instrument
Credit risk (default risk)
no
yes
Clearinghouse
yes
no
Settlement
marked-to-market (daily)
end of the contract
Margin requirement
yes
no
Transaction cost
low
high
Regulations
yes
no
RISK AND RETURN CHARACTERISTICS OF
FUTURES CONTRACTS
• Long futures: An investor whose opening position is the
purchase of a futures contract
• Short futures: An investor whose opening position is the sale
of a futures contract.
• The long will realize a profit if the futures price increases.
• The short will realize a profit if the futures price decreases.
Pricing of futures contracts
• To understand what determines the futures price, consider once again the
futures contract where the underlying instrument is Asset XYZ. The
following assumptions will be made:
1. In the cash market Asset XYZ is selling for $100.
2. Asset XYZ pays the holder (with certainty) $12 per year in four
quarterly payments of $3, and the next quarterly payment is exactly 3
months from now.
3. The futures contract requires delivery 3 months from now.
4. The current 3-month interest rate at which funds can be loaned or
borrowed is 8% per year.
What should the price of this futures contract be? That is, what should
the futures price be? Suppose the price of the futures contract is $107.
Consider this strategy:
• Sell the futures contract at $107.
• Purchase Asset XYZ in the cash market for $100.
• Borrow $100 for 3 months at 8% per year.
1. From Settlement of the Futures Contract
• Proceeds from sale of Asset XYZ to settle the
futures contract
• Payment received from investing in Asset XYZ
for 3 months
• Total proceeds
2. From the Loan
• Repayment of principal of loan
• Interest on loan (2% for 3 months)
• Total outlay
• Profit
= $107
= $3
= $110
= $ 100
=
2
= $102
= $8
Theoretical Futures Price Based On Arbitrage
Model
We see that the theoretical futures price can be determined based on the
following information:
1. The price of the asset in the cash market.($ 100)
2. The cash yield earned on the asset until the settlement date. In our
example, the cash yield on Asset XYZ is $3 on a $100 investment or 3%
quarterly (12% annual cash yield).
3. The interest rate for borrowing and lending until the settlement date. The
borrowing and lending rate is referred to as the financing cost. In our
example, the financing cost is 2% for the 3 months.
We will assign the following:
r = financing cost
y = cash yield
P = cash market price ($)
F = futures price ($)
• The theoretical futures price ;
F =P+P(r-y)
Our previous example to determine the theoretical futures
price ;
r= 00.2
y= 00.3
P= $ 100
Then , the theoretical futures prises is:
F= $ 100 + $ 100 ( 0.02 – 0.03 )
F= $ 100 - $ 1
F= $ 99
Difference Between Lending and Borrowing Rate
• The borrowing rate is greater than the lending rate.
• Letting;
rB = borrowing rate
rL = lending rate
F = P + p(rB-y)
F = P + p(rL-y)
• For example, assume that the borrowing rate is 8% per year,
or 2% for 3 months, while the lending rate is 6% per year, or
1.5% for 3 months. The upper boundary and lower boundary
for the theoretical futures price is:
• F(upper boundary) = $100 + $100(0.02 - 0.03)
= $ 99
• F(lower boudary) = $100 + $100(0.015 - 0.03)
= $ 98.50
General Principles of Hedging With Futures
• The major function of futures markets is to transfer price risk
from hedgers to speculators. That is, risk is transferred from
those willing to pay to avoid risk to those wanting to assume
the risk in the hope of gain. Hedging in this case is the
employment of a futures transaction as a temporary
substitute for a transaction to be made in the cash market.
The hedge position locks in a value for the cash position. As
long as cash and futures prices move together, any loss
realized on one position (whether cash or futures) will be
offset by a profit on the other position. When the profit and
loss are equal, the hedge is called a perfect hedge.
Risk Associated with Hedging
• The term r - y, which reflects the difference between the cost
of financing and the asset's cash yield, is called the net
financing cost. The net financing cost is more commonly
called the cost of carry or, simply, carry.
The amount of the loss or profit on a hedge will be determined
by the relationship between the cash price and the futures
price when a hedge is placed and when it is lifted. The
difference between the cash price and the futures price is
called the basis.
That is, basis = cash price - futures price
• if a futures contract is priced according to its theoretical value,
the difference between the cash price and the futures price
should be equal to the cost of carry. The risk that the hedger
takes is that the basis will change, called basis risk.
Cross-hedging
• Cross-hedging is common in asset/liability and portfolio
management because no futures contracts are available on specific
common stock shares and bonds. Cross-hedging introduces another
risk—the risk that the price movement of the underlying
instrument of the futures contract may not accurately track the
price movement of the portfolio or financial instrument to be
hedged. It is called cross-hedging risk.
• Therefore, the effectiveness of a cross-hedge will be determined by:
1. The relationship between the cash price of the underlying
instrument and its futures price when a hedge is placed and when it
is lifted.
2. The relationship between the market (cash) value of the
portfolio and the cash price of the instrument underlying the
futures contract when the hedge is placed and when it is lifted.
Long Hedge Versus Short Hedge
•
A short (or sell) hedge is used to protect against a decline in
the future cash price of a financial instrument or portfolio.
• To execute a short hedge, the hedger sells a futures contract
(agrees to make delivery).
• A long (or buy) hedge is undertaken to protect against an
increase in the price of a financial instrument or portfolio to
be purchased in the cash market at some future time.
• Thank you for listening,