Futures Market
Chapter 18

Understanding Futures Markets
Spot or cash market
 Price refers to item available for immediate delivery
 Spot price = today's price

Forward market
 Forward contracts are centuries old, traceable to at least the ancient Romans
and Greeks
 Any asset can be traded for future delivery between two parties on whatever
terms are agreeable to them through a forward contract.
 Price refers to item available for delayed delivery
 When the forward contract has:
1) Standardized amounts
2) A carefully defined asset
3) Deliverable on a specified date at a specified location
4) Subject to terms and conditions established by organized market
On which it is traded, then the contract is a futures contract
 Future markets standardizes the no standardized forward contracts

Futures market
 Organized future markets go back to the mid-nineteenth century in Chicago
 A future contract is an agreement that you will accept (or make) delivery of a
particular asset (either real or financial) on some date in the future at a price
determined today.
 Sets features (contract size, delivery date, and conditions of the item) for delivery
 Only price and the number of contracts are negotiated
 Long position-buyer
 Short position-seller
 Marked to market -- daily settlement of any gains or losses on the future
contracts are made.
 Future markets provide a secondary market for trading of contracts before
maturity.
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How is the Future Market Different from the Stock Market?
Losses must be covered, gains credited
Margin is usually quite small 3-10%
Margin is only a good faith deposit
Ownership is not transferred until delivery
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Understanding Futures Markets
Futures market characteristics
 Centralized marketplace allows investors to trade with each other
 Performance is guaranteed by a clearinghouse
Valuable economic functions
 Hedgers shift price risk to speculators
 If expect prices to rise hedge by buying a futures contract - If prices rise to more
than the future price, you experience a gain.
 If expect prices to fall hedge by selling a futures contract - If prices fall to more
than the future price, you experience a gain.
 Price discovery conveys information
Types of Futures
1) Commodities-agricultural, metals, and energy related
2) Foreign Exchange
3) Precious Metal
4) Financial
Stock Indexes
SP 500
SP Midcap 400
NYSE Composite
Major Market
Russell 2000
Nikkei 225, etc
Foreign Currencies
Japanese Yen
German Mark
Canadian Dollar
British Pound
Swiss Franc
Austrian Dollar
U.S. Dollar, etc.
Interest. Rate Futures
GNMA Pass Through
T-bills
T-bonds
T-notes
Commercial Paper
Large CD's
German Govt Bonds
Italian Govt Bonds, etc.
Example of Treasury Bond Future
(CBT)
Trading Unit
$100,000
Coupon
8%
Maturity
> 15 years from delivery date
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Delivery dates are also uniform on each exchange
 CBT futures specify delivery in March, June, September, or December up to
at least 2 years in the future quoted as a % of par with minimum of one
thirty-second of 1%.
 Financial futures have limits that price can fluctuate within a trading period
(day).
i.e. 3% for T-Bonds per day ($3,000)
Foreign futures markets
 Increased number shows the move toward globalization
 Markets quite competitive with US
Futures Contract
Standardized transferable agreement providing for the deferred delivery of either a
specified grade and quantity of a designated commodity with a specified geographical
area or of a financial instrument (or its cash equivalent)
 Trading means that a commitment has been made between buyer and seller
 Position offset by making an opposite contract in the same commodity
Since futures are not considered a security, they are not regulated by the SEC
Commodity Futures Trading Commission (CFTC) regulates trading
National Futures Association, a self-regulating body, assumes some of the regulatory
responsibilities of the CFTC
Futures Exchanges
Where futures contracts are traded
Voluntary, nonprofit associations, of membership
Organized marketplace where established rules govern conduct
 Financed by membership dues and fees for services rendered
Members trade for self or for others
All memberships owned by individuals, although may be controlled by firms
The Clearinghouse
A corporation separate from, but associated with, each exchange
Exchange members must be members or pay a member for these services
 Buyers and sellers settle with clearinghouse, not with each other
 Helps facilitate an orderly market
 Keeps track of obligations
 In every transaction the clearing house becomes the seller's buyer and the buyer's seller
as soon as the transaction is concluded.
 Buyers and sellers make transaction through commodity merchants who in turn
execute the transaction on an organized exchange.
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Buyers
A
** C
$90
obligation
to receive
$95
obligation
to receive
c
l
e
a
r
i
n
g
h
o
u
s
e
Sellers
$90
obligation
to deliver
B
$95
obligation
to deliver
A
*Offsetting
trade
*A has closed his position
**Both B and C have open positions
 Open positions (interests) get smaller as the delivery date gets closer (People offset their
positions so they have no obligation in the market).
The Mechanics of Trading
 Through open-outcry, seller and buyer agree to take or make delivery on a future date
at a price agreed on today
 Short position (seller) commits a trader to deliver an item at contract maturity
 A contract not previously purchased is sold
 Long position (buyer) commits a trader to purchase an item at contract maturity
 Like options, futures trading a zero sum game
 A future contract is an obligation to take or make a delivery—not a right
The Mechanics of Trading
 Contracts can be settled in two ways:
 Delivery (less than 2% of transactions)
 Offset: liquidation of a prior position by an offsetting transaction
 Each exchange establishes price fluctuation limits on contracts
 No restrictions on short selling
 No assigned specialists as in NYSE
 Brokerage commission paid on the basis of completed contract (purchase and sale),
rather than both the purchase and sale
 Open interest—the number of unliquidated contracts at any point in time (only the
short or the long position is counted—not both)
Futures Margin
 Earnest money deposit made by both buyer and seller to ensure completion of the
contract
 Not an amount borrowed from broker
 Each clearinghouse sets requirements for the minimum initial margin requirement
 Brokerage houses can require higher margin
 Initial margin usually less than 10% of contract value
 Margin calls occur when price goes against investor
 Must deposit more cash or close account
 Position marked-to-market daily
 Price used is the contract’s daily settlement price
 Profit can be withdrawn
 Each contract has maintenance or variation margin level below which earnest money
cannot drop
 Two types of margins requirements are usually specified by the exchanges and their
cleaning corporations:
1) Initial margin - earnest money required to open a position
2) Maintenance margin- reflects the level earnest money cannot fall below.

Examples of buying on margin:
Buy T-bond future @ 98 with 5% initial margin
Cost 100,000 x 98% =
Margin
Your acct with broker
Maintenance margin
Next day settle price
Gain/loss? Bought
Now
Change
98,000
.05
4,900
4,500
97-16
98
97.5
-.5%
Your account
4,900
<500> = -.5% (100,000)
4,400
below maintenance-- must bring up to initial margin
Deposit
500
4,900
3rd day settle at
97-04
Yesterday (2nd day)
Today (3rd day)
97-16
97-04
-12 = <$375> (12/32 of 1% of par)
Account
4,900
<375>
4,525 No maintenance call
Who Uses Futures Contracts
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Hedgers
 At risk with a spot market asset and exposed to unexpected price changes
 Used as a form of insurance
 Willing to forgo some profit in order to reduce risk
 Hedged return has smaller chance of low return but also smaller chance of high
 Producers:
 Use futures to protect the value of their production (risk is if prices fall).
 Consumers:
 Use futures to guard against rising prices for goods that they use.

Speculators
 Use futures to profit from price changes they believe will occur.
 Buy or sell futures contracts in an attempt to earn a return
 No prior spot market position
 Absorb excess demand or supply generated by hedgers
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Assuming the risk of price fluctuations that hedgers wish to avoid
Speculation encouraged by:
 Leverage- magnification of gains/losses
 Ease of transacting—easier to sell short in future market than the bond
market
 Low costs

Commodity Merchants
 Constitute the biggest single group of users.
 Act as middlemen who buy from producers and sell to users.

Commission brokers
 "floor brokers" - execute orders for customers
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Floor Traders  "locals" - execute orders for own account
Hedging
 Hedging: Taking a position in the futures market equal to and opposite an existing or
developed position in the cash or spot market.
 Hedgers must make timing decisions as to when to initiate and lift a hedge
 Types of Hedging
 Long
 Short
 Cross - hedging --use of a futures contract on one financial instrument to hedge
their position in a different financial instrument in the cash market -- success of
hedge depends on how well price movements are correlated between the future and
security hedged.

Short (sell) (Inventory) Hedge:
 Cash market inventory exposed to a fall in value
 Sell futures now to profit if the value of the inventory falls
 Short Hedge:
 Sell futures contract today as a temporary substitute for the sale of actual
commodity in the future.
I.E.: Assumption Bank anticipates increased loan demand in next 3 months and
plan to sell T-Bonds out of their portfolio.
Risk occurs if rates rise (prices fall)
Today:
Cash Market
Like to sell T-Bond
Future Market
Sell T-Bond futures
rates rise
Sometime in future:
Sell T-Bond
Loss
Perfect Short Hedge
April
Spot
Farmer estimates his wheat crop
@ 20,000 bu.
Current price $3.25 = 65,000
Sept.
Loss
Future
Sell 4 Sept. wheat @ 3.25 buy
4 x 5000 x 3.25 = 65,000
Price of wheat @ 3.00 sell crop
Buy wheat Contract @ 3.00 for
60,000
60,000
<5,000>
Gain 5,000
Sale of cash crop
Sale of future
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Buy T-Bond futures
Gain
60,000
5,000
65,000 or 3.25 bu
Long (buy) hedge
 Anticipated purchase exposed to a rise in cost
 Buy futures now to profit if costs increase
Assume: Bank anticipates weak loan demand in the near future and would like to invest in
$1 million of T-bonds in 3 months. The bank likes the current price and yield and would
like to lock into it now.
Risk: He fears prices (interest. rates) will rise (fall) in the next 3 months - He would then
have to reinvest his excess cash due to weak loan demand in higher priced securities.
How can the banker protect himself?
Long Hedge (Anticipatory): Purchase of futures contracts today as a temporary substitute
for the purchase of actual commodity in the future.
Long Hedge
Cash Market
Wish to take advantage of
20-year 8 1/4% T-Bonds @ 68-14
68,437.50 x 10 = $684,375
Today
(May)
Futures Market
Buys 10 September futures
@ 68-10
683,125
Interest. rates fall
(Lift the hedge)
Time in the future
(August)
Buy 1 mil. face value
20 year 8 1/4 T-bonds
@ 82-13
82,406.25 x 10 =
824,062.50
Loss: 139,687.50
Sell 10 September futures
@ 80-07
80218.75 x 10
802,187.50
Gain: 119,062.50
Effective Price
<824,062.50>
+ 119,062.50
705,000.00
When hedge exchange interest rate risk for basis risk.
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Hedging Risks
Basis: difference between cash price and futures price of hedged item
Basis risk: the risk of an unexpected change in basis
 Hedging reduces risk if basis risk less than variability in price of hedged asset
 Basis can be positive or negative depending on the relative prices between
cash and futures prices.
 reflective of "cost of carry" by security dealers in this security.
 "cost of carry" is net financing costs for holding securities in inventory.
 Yield cure
Positive Yield Curve
S-T rates < L T rates
Coupon Income and Capital Gain > Financing Costs
Cash Price > Future Price
(Positive Basis)
Negative Yield Curve
S-T rates > L-T rates
Coupon Rate and Capital Gain < Financing Cost
Cash Price < Future Price
(Negative Basis)
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Thus, the relationship between cash and future price can change due to changing
yield cure.
 If basis remains the same from the point in time when hedge is initiated to the point
in time when the hedge is lifted, then a perfect hedge has been created.
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Must be zero at contract maturity to have a perfect hedge
Risk cannot be entirely eliminated
 Liquidity
 ability to offset position
 Credit
 counter party defaults on contract
(OTC transactions-not applicable when trading on the exchanges)
 Prepayment
 assets hedged may be prepaid earlier than their designated maturity
- leaving you exposed
 Operational
 losses as a result of inadequate management or controls
Hedge Ratio:
If liabilities more rate sensitive than assets, then risk is that rates will increase.
 If rates rise, prices fall therefore buy or sell?
Basic risk arises due to the difference in the impact of change in interest rates between
the portfolio being hedged and the asset in the future contract.
 Determining the proportion of the portfolio to hedge:
the higher the proportion of the portfolio hedged the more insulated the manager's
performance from market moves
Hedge Ratio:
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1 ________
rate the future contract
changes for every % movement
in a portfolio being hedged.
If a future is less volatile than the portfolio, need a greater amount of principal to
hedge. i.e., 80% as volatile as portfolio (1/.8) = 1.25
Need: 1.25 x the principal of the portfolio
Financial Futures
Contracts on equity indexes, fixed income securities, and currencies
Opportunity to fine-tune risk-return characteristics of portfolio
At maturity, stock index futures settle in cash
 Difficult to manage delivery of all stocks in a particular index
At maturity, T-bond and T-bill interest rate futures settle by delivery of debt
instruments
 If expect increase (decrease) in rates, sell (buy) interest rate futures
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Increase (decrease) in interest rates will decrease (increase) spot and futures
prices
Difficult to short bonds in spot market
Hedging with Stock Index Futures
Selling futures contracts against diversified stock portfolio allows the transfer of
systematic risk
 Diversification eliminates nonsystematic risk but not systematic risk
 Hedging against overall market (systematic risk) decline
 Offset value of stock portfolio because futures prices are highly correlated with
changes in value of stock portfolios
Program Trading
Program trading: the use of computer-generated buy and sell orders for entire portfolio
based on arbitrage opportunities
Index arbitrage: a version of program trading
 Exploitation of price difference between stock index futures and index of stocks
underlying futures contract
 Arbitrageurs build hedged portfolio that earns low risk profits equaling the
difference between the value of cash and futures positions
Speculating with Stock Index Futures
Futures effective for speculating on movements in stock market because:
 Low transaction costs involved in establishing futures position
 Stock index futures prices mirror the market
Traders expecting the market to rise (fall) buy (sell) index futures
Futures contract spreads
 Both long and short positions at the same time in different contracts
 Intramarket (or calendar or time) spread
 Same contract, different maturities
 Intermarket (or quality) spread
 Same maturities, different contracts
 Interested in relative price as opposed to absolute price changes
 If two different contracts appear to be out of line, the spreader hopes to profit by
buying one contract and selling the other and waiting for the price difference to
adjust.