Chapter 17
Futures
Markets and
Risk
Management
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Futures and Forwards
• Forward - an agreement calling for a future
delivery of an asset at an agreed-upon price
• Futures - similar to forward but has standardized
terms and is traded on an exchange.
• Key difference in futures
– Futures have secondary trading (liquidity)
– Marked to market
– Standardized contract terms such as delivery dates,
price units, contract size
– Clearinghouse guarantees performance
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Key Terms for Futures Contracts
• The Futures price: agreed-upon price paid at maturity
• Long position: Agrees to purchase the underlying asset
at the stated futures price at contract maturity
• Short position: Agrees to deliver the underlying asset at
the stated futures price at contract maturity
• Profits on long and short positions at maturity
– Long = Futures price at maturity minus original futures price
– Short = Original futures price minus futures price at maturity
– At contract maturity T: FT= ST F = Futures price, S = spot price
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Figure 17.2 Profits to Buyers and Sellers
of Futures and Options Contracts
Why does the payoff for the call option differ from the long futures position?
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Types of Contracts
• Agricultural commodities
• Metals and minerals (including energy
contracts)
• Financial futures
– Interest rate futures
– Stock index futures
– Foreign currencies
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Table 17.1 Sample of Futures Contracts
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17.2 Mechanics of Trading
in Futures Markets
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The Clearinghouse and Open
Interest
• Clearinghouse - acts as a party to all buyers and sellers.
– A futures participant is obligated to make or take delivery at
contract maturity
• Closing out positions
– Reversing the trade
– Take or make delivery
– Most trades are reversed and do not involve actual delivery
• Open Interest
– The number of contracts opened that have not been offset with a
reversing trade: measure of future liquidity
17-8
Figure 17.3 Trading With and Without
a Clearinghouse
The clearinghouse eliminates counterparty default risk; this
allows anonymous trading since no credit evaluation is needed.
Without this feature you would not have liquid markets.
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Marking to Market and the Margin
Account
• Initial Margin: funds that must be deposited in a margin
account to provide capital to absorb losses
• Marking to Market: each day the profits or losses are
realized and reflected in the margin account.
• Maintenance or variance margin: an established value
below which a trader’s margin may not fall.
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Margin Arrangements
• Margin call occurs when the maintenance
margin is reached, broker will ask for
additional margin funds or close out the
position.
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Marking to Market Example
• On Monday morning you sell one T-bond futures contract at 97-27 (97
27/32% of the $100,000 face value). Futures contract price is thus
_________.
$97,843.75
• The initial margin requirement is $2,700 and the maintenance margin
requirement is $2,000.
Day
Settle
$ Value
Price Change
$97,843.75
Open
Margin
Account
Total %HPR
(cum.)
Spot HPR
(cum.)
$2700
Mon.
97-13
$97,406.25
-$437.50
$3137.50
16.2%
0.45%
Tues.
98-00
$98,000.00
$593.75
$2543.75
-5.8%
-0.16%
Wed.
100-00
$100,000.00
$2000.00
$543.75
-79.9%
-2.2%
Margin
Call
+$2156.25
$2700.00
Leverage multiplier ≈ 36
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Why delivery on futures is not an issue:
$110,000
• You go long on T-Bond futures at Futures0 = ___________
$108,000
• Suppose that at contract expiration, SpotT-Bonds = ________
• With daily marking to market, you have already given seller
$108,000
________,
so if you take delivery you only owe __________
$2,000
• With no delivery made
$2,000
– the seller of the T-Bonds could sell his bonds spot for __________
$108,000 from the daily
– and the seller has ALREADY gained __________
marking to market.
$110,000
– Net proceeds to seller ___________
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More on futures contracts
• Convergence of Price: As maturity approaches
the spot and futures price converge
• Delivery: Specifications of when and where
delivery takes place and what can be delivered
• Cash Settlement: Some contracts are settled in
cash rather than delivering the underlying assets
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Trading Strategies
• Speculation
– Go short if you believe price will fall
– Go long if you believe price will rise
• Hedging
– Long hedge: An endowment fund will purchase stock
in 3 months. The manager buys futures now to
protect against a rise in price.
– Short hedge: A hedge fund has invested in long term
bonds and is worried that interest rates may increase.
Could sell futures to protect against a fall in price.
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Figure 17.4 Hedging Revenues Using Futures,
Example 17.5 (Futures Price = $39.48)
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Basis and Basis Risk
• Basis - the difference between the futures
price and the spot price
– A hedger exchanges spot price risk for basis
risk.
– Basis is more stable than the spot price
– At contract maturity the basis declines to zero.
• Basis Risk - the variability in the basis that
will affect hedging performance
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17.4 The Determination of
Futures Prices
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Futures Pricing
• Spot-futures parity theorem
– Purchase the commodity now and store it to
T,
– Simultaneously take a short position in
futures,
– The ‘all in cost’ of purchasing the commodity
and storing it (including the cost of funds)
must equal the futures price to prevent
arbitrage.
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The no arbitrage condition
Action
1. Borrow So
2. Buy spot for So
Initial Cash
Flow
S0
-S0
Cash Flow at T
-S0(1+rf)T
ST
3. Sell futures
short
0
F0 - ST
Total
0
F0 - S0(1+rf)T
Since the strategy cost 0 initially, the cash flow at T must also equal 0.
Thus:
F0 - S0(1 + rf)T = 0
F0 = S0 (1 + rf)T
The futures price differs from the spot price by the cost of carry.
Can the cost of carry be negative?
17-20
Figure 17.6 Gold Futures Prices
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17.5 Financial Futures
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Stock Index Futures
• Available on both domestic and
international stocks
• Several advantages over direct stock
purchase
– lower transaction costs
– easier to implement timing or allocation
strategies
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Table 17.2 Stock Index Futures
17-24
Table 17.3 Correlations Among
Major US Stock Market Indexes
17-25
Creating Synthetic Stock
Positions
• Synthetic stock purchase
– Purchase of stock index futures instead of actual shares of stock
• Allows frequent trading at low cost, especially useful for foreign
investments
• Classic market timing strategy involves switching
between Treasury bills and stocks based on market
conditions.
– It is cheaper to buy Treasury bills and then shift stock market
exposure by buying and selling stock index futures.
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Index Arbitrage
• Exploiting mispricing between underlying stocks
and the futures index contract
• Futures Price too high:
– Short the futures and buy the underlying stocks
• Futures price too low:
– Long the futures and short sell the underlying stocks
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Index Arbitrage
• Difficult to do in practice
– Transactions costs are often too large,
– Trades must be done simultaneously
• SuperDot system assists in rapid trade execution
• ETFs available on indices
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Additional Financial Futures
Contracts
• Foreign Currency
– Forward contracts
• Currency markets are the largest markets in the
world,
• Forward contracts are available from large banks,
• Used extensively by firms to hedge foreign
currency transactions.
– Futures contracts are available for major
currencies at the CME, the LIFFE and others.
• March, June, September and December delivery
contracts are available.
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Figure 17.7 Spot and Forward Currency Rates
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Additional Financial Futures
Contracts
• Interest Rate Futures
– Major contracts include contracts on Eurodollars,
Treasury Bills, Treasury notes and Treasury bonds.
– Contracts on some foreign interest rates are also
available.
– A short position in these contracts will benefit if
interest rates increase and may be used to hedge a
bond portfolio.
– A long position benefits if interest rates fall. A bank
that has short term loans funded by longer term debt
could hedge its funding risk with a long position.
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Additional Financial Futures
Contracts
• Interest Rate Futures
– Hedging with futures will often require a cross
hedge.
• A cross hedge is hedging a spot position with a
futures contract that has a different underlying
asset.
– For example, hedge a corporate bond the firm owns by
selling Treasury bond futures.
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Swaps
• Large component of derivatives market
– Interest Rate Swaps
• One party agrees to pay the counterparty a fixed
rate of interest in exchange for paying a variable
rate of interest or vice versa,
• No principal is exchanged.
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Figure 17.8 Interest Rate Swap
Company A wants variable
Company B wants fixed
rate financing to match
rate financing. They will pay
their variable rate investments.
7.05%
They will pay LIBOR + 5 basis
points
Swap dealer agrees to
both deals, manages net risk
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Swaps
• Currency Swaps
– Two parties agree to swap principal and
interest payments at a fixed exchange rate
• Firm may borrow money in whatever currency has
lowest interest rate and then swap payments into
the currency they prefer.
– In 2007 there were $272 trillion notional
principal in interest rate swaps outstanding
and about $12.3 trillion principal in currency
swaps. (Source, BIS)
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