Chapter 18
Futures Contracts
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–1
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.
•
Have some understanding of the determinants
of futures price.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–2
Learning Objectives (cont.)
•
Understand and be able to explain that
speculation and hedging with futures contracts
may be imperfect.
•
Understand and explain the features of the major
financial futures contracts traded on the Sydney
Futures Exchange.
•
Explain speculation and hedging strategies using
the major financial futures contracts traded on the
Sydney Futures Exchange.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–3
Learning Objectives (cont.)
•
Understand the valuation of 90-day bank-accepted
bill futures contracts and share-price index futures
contracts.
•
Understand and explain the uses of forward-rate
agreements.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–4
Futures Contracts
•
A futures contract is an agreement which
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
Sydney Futures Exchange (SFE).
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
18–5
Forward Contracts
•
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 is the subject of the
contract are spelt out.
–
The contract is a private contract between you and I.
I cannot pass on to anyone else my responsibility to
deliver the commodity and, likewise, you cannot pass
on to anyone else your responsibility to accept delivery
of the commodity.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–6
Futures Contracts
•
A futures contract on gold will also have features
1 and 2 of a forward contract.
•
However, feature 3 is not true of a futures contract.
–
A futures contract is not a personalised agreement.
–
It is essentially a forward contract which can be traded
on an exchange.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–7
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.
•
Contracts usually closed out at or before maturity
rather than physically delivered.
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Prepared by Dr Buly Cardak
18–8
Deakin Futures Market
Date
Number
Price $
Price $
Number
1 March
B1
610
610
S1
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18–9
Deakin Futures Market (cont.)
Date
Number
Price $
Price $
Number
1 March
B1 = S1
610
610
B1 = S1
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Prepared by Dr Buly Cardak
18–10
Deakin Futures Market (cont.)
Date
Number
Price $
Price $
Number
1 March
B1 = S1
610
610
B1 = S1
1 March
B2 = S2
611
611
B2 = S2
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Prepared by Dr Buly Cardak
18–11
Deakin Futures Market (cont.)
Date
Number
Price $
Price $
Number
1 March
B1 = S1
610
610
B1 = S1
1 March
B2 = S2
611
611
B2 = S2
1 March
B12 = S12
608
608
B12 = S12
1 March
B19 = S19
615
615
B19 = S19
1 March
B37 = S37
614
614
B37 = S37
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Prepared by Dr Buly Cardak
18–12
Deakin Futures Market (cont.)
Date
Number
Price $
Price $
Number
1 March
B1 = S1
610
610
B1 = S1
1 March
B2 = S2
611
611
B2 = S2
1 March
B12 = S12
608
608
B12 = S12
1 March
B19 = S19
615
615
B19 = S19
1 March
B37 = S37
614
614
B37 = S37
8 March
B200 = S200
620
620
B200 = S200
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PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–13
Deakin Futures Market (cont.)
Date
Number
Price $
Price $
Number
1 March
B1 = S1
610
610
B1 = S1
1 March
B2 = S2
611
611
B2 = S2
1 March
B12 = S12
608
608
B12 = S12
1 March
B19 = S19
615
615
B19 = S19
1 March
B37 = S37
614
614
B37 = S37
8 March
B200 = S200
620
620
B200 = S200
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PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–14
Deakin Futures Market (cont.)
Date
Number
Price $
1 March
Price $
Number
610
B1 = S1
1 March
B2 = S2
611
611
B2 = S2
1 March
B12 = S12
608
608
B12 = S12
1 March
B19 = S19
615
615
B19 = S19
1 March
B37 = S37
614
614
B37 = S37
8 March
B200 = S200
620
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Prepared by Dr Buly Cardak
18–15
Deakin Futures Market (cont.)
•
•
•
B1 owes the clearing house $610.
B1 (=S200) is owed by the clearing house $620.
Therefore, the clearing house owes B1 $10.
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18–16
Deakin Futures Market (cont.)
•
Buyers and sellers do not need to know the
identity or credit worthiness of other buyers
and sellers.
•
But B1 must notify exchange that she is S200.
•
Note no silver changed hands.
•
Note ‘short selling’ is possible.
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18–17
Deposits, Margin Calls and the Markto-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.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
18–18
The Present Value of a Futures
Contract
•
A futures contract does not require a payment on
initiation, so it is clear that the present value of a
futures contract must be zero.
•
Accordingly, it is, in a sense, impossible to
calculate a rate of return on a futures contract.
–
If the outlay is zero, any subsequent gain is an infinite
percentage gain and any subsequent loss is an infinite
percentage loss.
Copyright  2006 McGraw-Hill Australia Pty Ltd
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Prepared by Dr Buly Cardak
18–19
The Sydney Futures Exchange (SFE)
•
Opened for trading in 1960, was then called
Sydney Greasy Wool Futures Exchange —
reflecting the importance of the commodity
(agricultural) futures at that stage.
•
SFE operates own clearing house to:
–
Establish and collect deposits.
–
Call in margins.
–
Apportion the gains and losses.
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18–20
SFE Contracts
•
The contracts available include:
–
–
–
–
–
–
–
–
•
90-day bank accepted bills
3-year Australian Treasury Bond
10-year Australian Treasury Bond
Standard & Poors, ASX 200 (SPI200)
30-day inter-bank cash rate contract
Individual share futures (on approximately ten
companies)
Australian dollar
Options on futures contracts
The bulk of trading on the SFE is in the first four
contracts listed above.
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18–21
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.
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18–22
Determinants of Futures Prices
(cont.)
•
Substituting ‘the spot price’ for ‘the futures price
for an equivalent early-delivery contract’, the
theorem becomes:
–
•
A futures price must be less than (or equal to) the current
spot price plus the carrying cost.
In this way, the theorem provides a maximum price
for the futures contract, given the current spot
price and the carrying cost.
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18–23
Determinants of Futures Prices
(cont.)
Algebraically, the theorem can be written as:
F  S C
where:
F  futures price
S  current spot price
C  carrying cost
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18–24
Determinants of Futures Prices
(cont.)
•
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:
E  S   S  C  risk factor
•
Clearly, there must be some linkage between the expected
spot price and the futures price.
•
If there is a big difference between the expected spot price
and futures price, it may reflect an arbitrage opportunity,
depend on perceptions about the risk factor.
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Prepared by Dr Buly Cardak
18–25
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, the speculator is exposed
to the risks of changes in the futures price — a risk to
which they would not otherwise have been exposed.
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PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
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18–26
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
pre-existing risk of changes in the commodity
price itself.
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Prepared by Dr Buly Cardak
18–27
Speculating
•
•
In the simplest case, a speculator hopes to:
–
Take a long position (that is, buy) when the futures price
is ‘low’, reversing out (that is, selling later) when the
futures price has increased; and/or
–
Take a short position (that is, sell) when the futures price
is ‘high’, reversing out (that is, 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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18–28
Speculating (cont.)
Basic speculator outcomes
IF FUTURES CONTRACT IS HELD
IF FUTURES PRICES SUBSEQUENTLY:
INCREASE
DECREASE
Long
Gain
Loss
Short
Loss
Gain
Table 18.2
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18–29
Speculating (cont.)
•
Scalping:
–
A scalper will only hold a futures contract for an extremely
short time period (seconds or minutes).
–
Scalpers try to develop a continuously updated ‘feel’ for
the market, anticipating and exploiting perceived shortterm excesses of supply or demand.
–
Scalpers perform the useful function of providing liquidity
to the market.
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18–30
Speculating (cont.)
•
Spreading
–
A ‘spread’ is a long (bought) position in one maturity
date, paired with a short (sold) position in another
maturity date.
–
Example — A bought March bank bill futures and A sold
June bank bill futures.

This spread will be adopted if speculators believe that the
current difference between the two futures prices is too
wide.

Speculators will gain if the difference (or ‘spread’) narrows.
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Speculating (cont.)
•
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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Speculating (cont.)
•
Day trading
–
•
Day traders are prepared to trade as they see fit during a
trading day, but regard an overnight position as too risky.
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.
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18–33
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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Hedging (cont.)
• Short hedger
–
Someone who hedges by means of selling futures
contracts today (going short).
Short hedging outcomes
IF PRICES RISE
IF PRICES FALL
Short futures contract
Loss
Gain
Cattle - spot
Gain
Loss
Net result
Approximately zero Approximately zero
Table18.3
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Hedging (cont.)
• Long hedger
–
Someone who hedges by means of buying futures
contracts today (going long).
Long hedging outcomes
IF PRICES RISE
IF PRICES FALL
Long futures contract
Gain
Loss
Cattle - spot
Loss
Gain
Approximately zero
Approximately zero
Net result
Table 18.4
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18–36
Some Reasons 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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18–37
Some Reasons 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 date of the
planned spot transaction to coincide with the maturity
date of a futures contract.
–
Futures exchanges will offer only a restricted number of
maturity dates.
–
When the dates do not coincide, the hedger must reverse
out of the futures contract before it matures and faces a
risk known as ‘basis risk’.
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Some Reasons Why Hedging With
Futures is Imperfect (cont.)
–
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:
–
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 increase (decreases).
B (1) = S (1) – F (1)
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Some Reasons Why Hedging With
Futures is Imperfect (cont.)
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
•
The point is simple: the change in the basis
over a given time period is not, in general,
precisely zero.
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Some Reasons Why Hedging With
Futures is Imperfect (cont.)
•
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.
–
Example: a hedger may be interested in a particular
grade of wool that is slightly different to the grade of wool
specified in the futures contract.
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Hedging and Regretting
•
Hedging can be used to reduce losses which
would otherwise have been incurred.
•
However, it should not be forgotten that, by its very
nature, hedging also reduces profits which would
otherwise have been made.
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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:
N s S0
f 
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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The Bank Bill Futures Contract
•
Contract specifications for 90-day bankaccepted bills:
–
–
–
–
–
–
Contract unit — 90-day bank accepted bill with a face
value of $1m.
Delivery months — Mar., June, Sept., 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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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 rates are 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%).
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Hedging with Bank Bill Futures (cont.)
•
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?
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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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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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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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).
–
Trading ceases at 12 noon on the third Thursday
of the contract month.
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PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–49
Speculation with the SPI Futures
•
Example
–
On 1 September 2004, the S&P/ASX 200 Index closed
at 3575.6 and the December (2004) SPI200 futures price
was 3598.
–
Suppose that a speculator believes that share prices
are likely to rise in the following two weeks and therefore
decides to buy December SPI200 futures.
–
On 15 September 2004, the S&P/ASX 200 Index has
risen to 3625.1 and the December SPI futures price has
fallen to 3638.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–50
Speculation with the SPI Futures
(cont.)
• The total gain can be calculated as follows:
Notional sale at:
3598 x $25 = $89 950 (outflow)
Notional purchase at: 3328 x $25 = $90 950 (inflow)
Gain (net inflow):
$1 000
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–51
Hedging with SPI Futures
•
Example 18.14
–
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 3162.
–
Assume that proportionate changes in the portfolio’s
value will be matched by proportionate changes in the
futures price.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–52
Hedging with SPI Futures (cont.)
Number of futures contracts needed to hedge the
portfolio:
N s S0
f 
N f F0
*
value of spot position

value of one futures contract
$1500000

3162  $25
 19.11  19
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–53
Hedging with SPI Futures (cont.)
Hedging outcome in Example 18.14
DATE
SPI FUTURES PRICE
PER CONTRACT
(INDEX FORM)
SPI FUTURES PRICE
FOR 28 CONTRACTS
($)
PORTFOLIO
VALUE
($)
When hedge entered
3162 (sold)
1 501 950
1 510 700
3009 (bought)
1 429 275
1 444 450
72 675
(66 250)
When hedge lifted
Gain (loss)
Table 18.11
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–54
Hedging with SPI Futures (cont.)
•
Therefore the hedge has, in fact, resulted in a net
gain of:
$72 675 – $66 250 = $6 425
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–55
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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–56
Valuation of Financial Futures
Contracts (cont.)
• 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–57
Valuation of Bank Bill Futures
Contracts
• If it is assumed that bank bills can be sold
short, then the above equation should apply
to bank bill futures.
–
It is usual to express C in terms of the yield it applicable
to the term t of the future contract.
F  S 1  it 
–
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.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–58
Valuation of SPI Futures Contracts
 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
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–59
Forward Rate Agreements
•
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 a FRA will be
a bank or some other financial institution.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–60
Example of 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%.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–61
Example of FRA (cont.)
•
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).
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–62
Speculation — Barings
•
Barings Bank is a notorious example of futures
speculation gone wrong.
•
Barings Bank collapsed in 1995 because of
futures losses incurred by a Singapore-based
trader, Nick Leeson.
•
He bought Japanese stock index futures contracts
on the Singapore International Money Exchange
(SIMEX) and sold them on the Osaka exchange.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–63
Speculation — Barings (cont.)
•
This is basically an arbitrage activity, which in
efficient markets (or on average) should not yield
excess returns.
•
However, he managed to separate losses and
profits into two separated accounts, exposing
profits of ¥28m and hiding losses of ¥180m.
•
In January 1995, he took long positions in
Japanese stock index futures, hoping they would
rise and deliver a profit.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–64
Speculation — Barings (cont.)
•
However, an earthquake in Japan caused the
market to fall 13%, delivering huge losses.
•
Leeson fled Singapore with US$3b in open
positions, which resulted in total losses of
US$1.4b.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–65
Hedging — Metallgesellschaft
•
Metallgesellschaft was a German company
operating in the US as MG Refining and
Marketing(MGRM).
•
In 1992, sales strategy of offering US firms longterm fixed-price contracts on gasoline, heating oil
and diesel fuel.
•
If firms agreed to buy from MGRM, they would
receive 10-year fixed-price contracts.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–66
Hedging — Metallgesellschaft (cont.)
•
These contracts could result in large losses for
MGRM if oil prices rose significantly.
•
To cover their obligations, MGRM bought long
positions on the New York Mercantile Exchange.
•
Problem: 10-year futures contracts did not exist.
•
Solution: MGRM bought the longest contracts
available and, when they expired, rolled over into
new ones.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–67
Hedging — Metallgesellschaft (cont.)
•
In 1993, oil prices fell by one-third.
•
This was good for the business with contracts to
deliver at fixed prices.
•
However, the futures contracts incurred large
losses, offsetting potential profits and resulting in
large margin calls.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–68
Hedging — Metallgesellschaft (cont.)
•
The gains on their contracts to deliver would not
be realised for up to 10 years.
•
Their futures losses were being margin called
immediately.
•
Parent company decided to liquidate futures
contracts, incurring losses.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–69
Hedging — Metallgesellschaft (cont.)
•
Soon after, oil prices rose and the potential gains
on contracts to deliver over the next 10 years
disappeared, serving a double blow to the
company.
•
Company losses for the year totalled US$1.7b.
•
If the firm could have raised funds to meet margin
calls, the hedge probably would have succeeded.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–70
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.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–71
Summary (cont.)
•
Futures can be used for hedging or for
speculation.
•
Futures 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.
Copyright  2006 McGraw-Hill Australia Pty Ltd
PPTs t/a Business Finance 9e by Peirson, Brown, Easton, Howard and Pinder
Prepared by Dr Buly Cardak
18–72