Chapter 17: Futures Markets and Risk Management
 17.1 The Futures Contract
o both parties can reduce this source of risk is they enter into a forward
contract an arrangement calling for future delivery of an asset at an agreed
upon price.
o No money need change hands at the time a forward contract is simply a
deferred delivery sale of some asset with the sales price agreed upon now
o All that is required is that each party be willing to lock in the ultimate price
for delivery of the commodity protects each party from price fluctuations
o Futures markets formalize and standardize the types of contracts that may
be trade: it establishes contract size, the acceptable grade of commodity,
contract delivery dates etc
o Eliminates much of the flexibility available in informal forward contracting it
had the offsetting advantage of liquidity because many traders will
concentrate on the same small set of contracts
o Futures contracts also differ from forward contract in that they call for a
daily settling up of any gains or losses on the contract
o Standardization of contract and the depth of trading in each contract allows
futures positions to be liquidated easily rather than personally renegotiated
with the other party to the contract
o Each trader simply posts a good faith deposit, called the margin, in order to
guarantee contract performance
o The Basics of Futures Contracts
 The futures contact calls for delivery of a commodity at a specified
delivery or maturity sate for an agreed upon price, called future
prices, to be paid at contract maturity specifies precise
requirements for the commodity
 Futures price: the agreed upon price to be paid on a futures contract
at maturity
 Long position: the futures trader who commits to purchasing the asset
 Short position: the futures trader who commits to delivering the asset
 The trader holding to long position profits from price increases
 Profit to long = spot price at maturity – original futures price
 Profit to short = original futures price – spot price at maturity
 A futures contract is a zero sum game, with losses and gains to all
positions netting out to zero
 The futures investor is exposed to considerable losses if the asset
price falls
o Existing Contracts
 Futures and forward contracts are traded on a wide variety of goods
in four broad categories: agricultural commodities, metals and
minerals (including energy commodities), foreign currencies and
financial futures (fixed income securities and stock market indexes)
 One can now trade on single stock features a futures contract on the
shares of an individual company
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17.2 Trading Mechanics
o The Clearinghouse and Open Interest
 Today, trading is overwhelmingly conducted through electronic
networks, particularly for financial futures
 Clearinghouse: established by exchanges to facilitate trading. The
clearinghouse may interpose itself as an intermediary between two
traders
 Becomes the seller of the contract for the long position and the buyer
of the contract for the short position once a trade is agreed to
 Obligated to deliver the commodity to the long position and to pay for
delivery from the short, consequently, the clearinghouse’s position
nets to zero
 Only party that can be hurt by the failure of any trader to observe te
obligations of the futures contract
 Clearinghouse becomes an intermediary, acing as the trading partner
for each side of the contractneutral position
 Makes it possible for traders to liquidate positions easily
 Reverse trade: instruct your broker to enter the short side of a
contract to close your position
 Your zero net position with the clearinghouse eliminates the need to
fulfill at maturity either the original long or reverse short position
 Open interest: on the contract is the number of contracts outstanding
o Marking to Market and the Margin Account
 The process by which profits or losses accrue to traders marking to
market
 The margin of security account consists of cash or near cash securities
 Both parties must post margin
 Contract written on assets with more volatile prices require higher
margins
 Clearinghouse requires all positions to recognize profits as they
accrue daily
 Therefore, as future prices change, proceeds accrue to the traders
account immediately
 Sustained losses from daily marking to market, the margin account
may fall below a critical value called the maintenance margin am
established value below which a traders margin may not fall. Reaching
the maintenance margin triggers a margin call
 Trader receives a margin call requiring that the margin account be
replenished or the position to be reduced to a size commensurate
with the remaining foods. Margins and margin calls safeguard the
position of the clearinghouse
 On the contract maturity date, the futures price will equal the spot
price of the commodity
 Spot price: the cost of the commodity from the two competing sources
is equalized in a competitive market
A commodity available from two sources (the spot and future
markets) must be prices identically
 The futures price and the spot price must converge at maturity
convergence property: the convergence of futures prices and spot
prices at the maturity of the futures contract
 Profits on a futures contract held to maturity perfectly track changes
in the value of the underlying asset
o Cash versus Actual Delivery
 Most futures markets call for delivery of an actual commodity
 Some futures contracts call for cash settlement the cash value of the
underlying asset (rather than the asset itself) is delivered to satisfy
the contract
 Cash settlement closely mimics actual delivery, except the cash value
of the asset rather than the asset itself is delivered by the short
position in exchange for the futures price
o Regulations
 Futures markets are regulated by the Commodity Futures Trading
Commission (CFTC) set limits on the amount prices can change in
one day
o Taxation
 Because of the mark to market procedure, investors do not have
control over the tax year in which they realize gains or losses
 Taxes are paid at year-end on cumulated profits or losses regardless
of whether the position have been closed out
17.3 Futures Market Strategies
o Hedging and Speculation
 Hedging and Speculating are two polar uses of futures market
 A speculator uses a futures contract to profit from movements in
futures prices; a hedger, to protect against price movements
 If speculators believe prices will increase, they will take a long
position for expected profits. Conversely, the exploit expected price
declines by taking a short position
 Allow speculators to achieve much greater leverage that is available
from direct trading in a commodity
 Use futures to insulate themselves against price movements
 Short hedge: taking s short futures position to offset risk in the sales
price of a particular asset
 Long hedge: the analogous hedge for someone who wishes to
eliminate the risk of uncertain purchase price
 Hedging is a position using futures on another asset cross hedging
o Basis Risk and Hedging
 Basis: is the difference between the futures price and the spot price
 Basis Risk: risk attributable to uncertain movements in the spread
between a futures price and a spot prices
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Risk is eliminated because the futures price and the spot price at
contract maturity must be equal: gains and losses on the futures and
the underlying asset will exactly cancel
 If the contract and asset are to be liquidated early, before contract
maturity, however, the hedger bears basis risk, because the futures
price and the spot price need not move in perfect lockstep until the
delivery date
 Some speculators try to profit from movements in the basis
 Spread (futures): taking a long position in a futures contract of one
maturity and short position in a contract of a different maturity, both
on the same commodity
 Spread positions aim to exploit movements in relative price structures
rather than to profit from movements in the general level of prices
17.4 Futures Prices
o Spot-Futures Parity
 Tow ways to obtain an asset at some date in the future. One way is to
purchase it now and store it until the targeted date
 The other way is to take a long futures position that calls for purchase
of the asset on the date in question
 Cost of pursuing these strategies to be equal there should be a
predictable relationship between the current price of the asset,
including the costs of holding and storing it, and the futures price
 The cost, or initial cash outflow, required by these strategies also must
be equal
 Spot futures parity theorem or cost of carry relationship: describes
the theoretically correct relationship between spot and futures prices.
Violation of the parity relationship gives rise to arbitrage
opportunities
 When d < rf, the income yield on the stock actually exceeds the
forgone (risk free) interest rate that could be earned on the money
invested; in this event, the futures price will be less than the current
stock price, again by greater amounts for longer maturities
o Spreads
 To determine the proper relationships among futures prices for
contract of different maturity dates
 Futures prices should al move together futures prices for different
maturity dates move in unison, for all are linked to the same spot
price through the parity relationship
17.5 Financial Returns
o Stock Index Futures
 These contracts are settled by a cash amount equal to the value of the
stock index in question on the contract maturity date times a
multiplier that scales the size of the contract
o Creating Synthetic Stock Positions
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Stock-index futures are so popular because they can substitute for
holdings in the underlying stocks themselves lets investors
participate in broad market movements without actually buying or
selling large numbers of stocks
 We say futures represent synthetic holdings of the market position
 Instead of holding the market directly, the investor takes a long
futures position in the index transaction costs involved in
establishing and liquidating futures positions are much lower than
what would be required to take actual spot positions
 One way to market time is to shift between treasury bills and broad
based stock market holdings
 Can result in huge trading costs
 Strategy: when timers are bullish, they will establish many long
futures positions that they can liquidate quickly and cheaply when
expectation turn bearish Buy and hold T-bills and adjust only the
future positions minimize transaction costs investors can
implicitly buy or sell the market index in its entirety
o Index Arbitrage
 Whenever the actual futures price differs from its parity value, their is
an opportunity for profit
 Index arbitrage: strategy that exploits divergences between actual
futures prices and their theoretically correct parity values to make a
riskless profit
 Index arbitrage can be difficult to implement 1. Transaction costs
2. Call for the purchase or sale of shares of 500 different firm
simultaneously
 Need to be able to trade an entire portfolio of stocks quickly and
simultaneously if they hope to exploit temporary disparities between
the futures price and its corresponding stock index
 Program trading: coordinated buy orders and sell order of entire
portfolios, often to achieve index arbitrage objectives
o Foreign Exchange Futures
 Dollar value of other currencies depends on the exchange rate at the
time the payment is made
 Exposed to foreign exchange rate risk
 You can sell those pounds in forward today in the forward market and
lock in an exchange rate equal to todays forward price
 Contracts in these markets are not standardized in a formal market
setting. Instead, each is negotiated separately there is not marking
to market as would occur in future markets. Forward contracts call for
execution only at the maturity date
o Interest Rate Futures
 The major US interest rate contracts currently trade are on
Eurodollars, T-bills, treasury notes, and treasury bonds the range of
these securities provides an opportunity to hedge against interest rate
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risk in a wide spectrum of maturities from very shot (T-bills) to long
term (t-bond)
The treasury contracts call for delivery of a Treasury bond, bill, or
note
Price value of a basis point: the change in the value of an asset due to a
1-basis-point change in its yield to maturity represents the
sensitivity of the dollar value of the portfolio to changes in interest
rates
One way to hedge this risk is to take an offsetting position in an
interest rate futures contract
Hedging problem in practice is more difficult interest rates on
various fixed income instruments do tend to vary in tandem, there is
considerable slippage across sectors of the fixed income market
Most hedging is cross hedging hedging a position in one asset by
establishing an offsetting position in a related but different asset
can eliminate a large fraction of the total risk of the unprotected
portfolio
17.6 Swaps
o Swaps are multiperiod extensions of forward contracts
o Foreign exchange swap: an agreement to exchange a sequence of payments
denominated in one currency for payments in another currency at an
exchange rate agreed to today
o Swaps and Balance Sheet Restructuring
 Appeal to fixed income managers these contracts provide a means
to quickly, cheaply, and anonymously restructure the balance sheet
 Issue floating rate debt and use the proceeds to buy back the
outstanding fixed rate debt or vice versa
 Swaps enable managers to switch back and forth between a fixed or
floating rate profile quickly and cheaply as the forecast for the interest
rate changes
 A manager who holds a fixed rate profile can transform it into a
synthetic floating rate portfolio by entering a pay fixed receive
floating swap and can later transform it back by entering the opposite
side of a similar swap
o The Swap Dealer
 Typically a financial intermediary (bank)
 Dealer becomes little more than an intermediary, funneling payments
from one party to the other the dealer find this profitable because it
will charge a bid ask spread on the transaction