Chapter 18
Futures Contracts and
Forward Rate
Agreements
Websites:
www.sfe.com.au
www.cme.com
www.cbot.com
www.liffe.com
www.hkex.com.hk
www.sgx.com
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-1
Learning Objectives
• Consider the nature and purpose of derivative
products
• Outline features of futures contracts and forward
rate agreements and market operating procedures
• Identify why participants use derivative markets
and how futures are used to hedge price risk
• Explain how using derivatives to manage one risk
may create a new risk exposure
• Explain and illustrate the use of an FRA for
hedging interest rate risk
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-2
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-3
18.1 Hedging Using Futures Contracts
• Futures contracts and FRAs are called derivatives
because they derive their price from an underlying
physical market product
• Two main types of derivative contracts
– Commodity (e.g. gold, wheat and cattle)
– Financial (e.g. shares, government securities and money
market instruments)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-4
18.1 Hedging Using Futures Contracts
(cont.)
• Derivative contracts enable investors and
borrowers to protect assets and liabilities against
the risk of changes in interest rates, exchange
rates and share prices
• Hedging involves transferring the risk of
unanticipated changes in prices, interest rates or
exchange rates to another party
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-5
18.1 Hedging Using Futures Contracts
(cont.)
• A futures contract is the right to buy or sell a
specific item at a specified future date at a price
determined today
• The change in the market price of a commodity or
security is offset by a profit or loss on the futures
contract
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-6
18.1 Hedging Using Futures Contracts
(cont.)
• Example: A farmer wants to sell wheat in a couple
of months, but is concerned that the price is going
to fall in the meantime. How can the farmer hedge
this price risk?
– Solution
 Enter into a wheat futures contract to sell
• If wheat prices fall, the futures contract will rise in value,
offsetting the loss in the physical market from the fall in the
wheat price
• If wheat prices rise, the futures contract will fall in value,
offsetting the gain in the physical market from a rise in the
wheat price
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-7
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-8
18.2 Main Features of Futures
Transactions
• Although futures contracts are highly standardised
variations between countries exist due to
– The types of contract being based on the underlying
security traded in that country
 SFE (Sydney Futures Exchange) Commonwealth Treasury
bonds; CBOT (Chicago Board of Trade) US Treasury bonds
– Differences in the quotation convention
 Clean price bond quotation in US and European markets—
present value of a bond less accrued interest
 Yield to maturity bond quotation in Australian markets
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-9
18.2 Main Features of Futures
Transactions (cont.)
• Orders and agreement to trade
– Futures contracts are highly standardised and an order
normally specifies





Whether it is a buy or sell order
The type of contract (varies between exchanges)
Delivery month (expiration)
Price restrictions (if any) (e.g. limit order)
Time limits on the order (if any)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-10
18.2 Main Features of Futures
Transactions (cont.)
• Margin requirements
– Both the buyer (long position) and the seller (short
position) pay an initial margin, held by the clearing house,
rather than the full price of the contract
– Margins are imposed to ensure traders are able to pay for
any losses they incur due to unfavourable price
movements in the contract
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-11
18.2 Main Features of Futures
Transactions (cont.)
• Margin requirements (cont.)
– A contract is marked-to-market on a daily basis by the
clearing house
 i.e. repricing of the contract daily to reflect current market
valuations
– Subsequent margin calls may be made, requiring a
contract holder to pay a maintenance margin to top-up
the initial margin to cover adverse price movements
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-12
18.2 Main Features of Futures
Transactions (cont.)
• Closing out of a contract
– Involves entering into an opposite position
– Example
 Company S initially entered into a ‘sell one 10-year treasury
bond contract’ with company B
 Company S would close out the position by entering into a
‘buy one 10-year treasury bond contract’ for delivery on the
same date, with a third party, e.g. company R
• The second contract reverses or closes out the first contract
and company S would no longer have an open position in the
futures market
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-13
18.2 Main Features of Futures
Transactions (cont.)
• Contract delivery
– Most parties to a futures contract
 Manage a risk exposure or speculate
 Do not wish to actually deliver or receive the underlying
commodity/instrument and close out of the contract prior to
delivery date
– SFE requires financial futures in existence at the close of
trading in the contract month to be settled with the
clearing house in one of two ways
 Standard delivery—delivery of the actual underlying
financial security
 Cash settlement
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-14
18.2 Main Features of Futures
Transactions (cont.)
• Contract delivery (cont.)
– Settlement details, including the calculations of cash
settlement amounts, for each contract traded on the SFE
are available on the exchange’s website at
www.sfe.com.au
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-15
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-16
18.3 Futures Market Instruments
• Futures markets can be established for any
commodity or instrument that
– Is freely traded
– Experiences large price fluctuations at times
– Can can be graded on a universally accepted scale in
terms of its quality
– Is in plentiful supply, or cash settlement is possible
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-17
18.3 Futures Market Instruments (cont.)
• Examples
– Commodities
 Mineral—silver, gold, copper, petroleum, zinc
 Agricultural—wool, coffee, butter, wheat and cattle
– Financial
 Currencies—pound sterling, euro, Swiss franc
 Interest rates
• Short-term instruments—US 90-day treasury bills, 3-month
eurodollar deposits, Australian 90-day bank-accepted bills
• Longer-term—US 10-year T-notes, Australian 3-year and 10year Commonwealth Treasury bonds
• Share price indices — All Ordinaries
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-18
18.3 Futures Market Instruments (cont.)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-19
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-20
18.4 Futures Market Participants
• Four main categories of participants
–
–
–
–
Hedgers
Speculators
Traders
Arbitragers
• These participants provide depth and liquidity to
the futures market, improving its efficiency
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-21
18.4 Futures Market Participants (cont.)
• Hedgers
– Attempt to reduce the price risk from exposure to
changes in interest rates, exchange rates and share
prices
– Take the opposite position to the underlying, exposed
transaction
– Example
 An exporter has USD receivable in 90 days. To protect
against fall in USD over next 3 months, the exporter enters
into a futures contract to sell USD
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-22
18.4 Futures Market Participants (cont.)
• Speculators
– Expose themselves to risk in the attempt to make profit
– Enter the market in the expectation that the market price
will move in a favourable direction for them
– Example
 Speculators who expect the price of the underlying asset to
rise will go long and those that expect the price to fall will go
short
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-23
18.4 Futures Market Participants (cont.)
• Traders
– Special class of speculator
– Trade on very short-term changes in the price of futures
contracts (i.e. intra-day changes)
– Provide liquidity to the market
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-24
18.4 Futures Market Participants (cont.)
• Arbitragers
– Simultaneously buy and sell to take advantage of price
differentials between markets
– Attempt to make profit without taking any risk
– Example
 Differentials between the futures contract price and the
physical spot price of the underlying commodity
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-25
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-26
18.5 Hedging: Risk Management Using
Futures
• Futures contracts may be used to manage
identified financial risk exposures such as
–
–
–
–
Hedging the cost of funds (borrowing hedge)
Hedging the yield on funds (investment hedge)
Hedging a foreign currency transaction
Hedging the value of a share portfolio
Copyright  2007 McGraw-Hill Australia Pty Ltd
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Slides prepared by Anthony Stanger
18-27
Hedging the cost of funds (borrowing
hedge)
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18-28
Hedging the yield on funds (investment
hedge)
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18-29
Hedging a foreign currency transaction
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18-30
Hedging the value of a share portfolio
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-31
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-32
18.6 Risks in Using Futures Markets for
Hedging
• The risks of using the futures markets for hedging
include the problems of
–
–
–
–
Standard contract size
Margin risk
Basis risk
Cross-commodity hedging
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-33
18.6 Risks in Using Futures Markets for
Hedging (cont.)
• Standard contract size
– Due to contract size the physical market exposure may not
exactly match the futures market exposure, making a perfect
hedge impossible
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-34
18.6 Risks in Using Futures Markets for
Hedging (cont.)
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PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-35
18.6 Risks in Using Futures Markets for
Hedging (cont.)
• Margin payments
– Initial margin required when entering into a futures
contract
– Further cash required if prices move adversely (i.e.
margin calls)
– Opportunity costs associated with margin requirements
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
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18-36
18.6 Risks in Using Futures Markets for
Hedging (cont.)
• Basis risk
– Two types of basis risk
 Initial basis
• The difference between the price in the physical market and
the futures market at commencement of a hedging strategy
 Final basis
• The difference between the price in the physical market and
the futures market at completion of a hedging strategy
– A perfect hedge requires zero initial and final basis risk
Copyright  2007 McGraw-Hill Australia Pty Ltd
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18-37
18.6 Risks in Using Futures Markets for
Hedging (cont.)
• Cross-commodity hedging
– Use of a commodity or financial instrument to hedge a
risk associated with another commodity or financial
instrument
 Often necessary as futures contracts are available for few
commodities or instruments
– Selection of a futures contract that has price movements
that are highly correlated with the price of the commodity
or instrument to be hedged
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-38
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.9
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-39
18.7 Forward Rate Agreements (FRAs)
• The nature of the FRA
– An FRA is an over-the-counter product enabling the
management of an interest rate risk exposure
 It is an agreement between two parties on an interest rate
level that will apply at a specified future date
 Allows the lender and borrower to lock-in interest rates
 Unlike a loan, no exchange of principal occurs
 Payment between the parties involves the difference
between the agreed interest rate and the actual interest rate
at settlement
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-40
18.7 Forward Rate Agreements (FRAs)
(cont.)
• The nature of the FRA (cont.)
– Disadvantages of FRAs include
 Risk of non-settlement, i.e. credit risk
 No formal market exists
– The FRA specifies






Trade or contract date
Notional principal amount
Contract period in which the FRA interest rate will be based
FRA agreed rate
FRA settlement reference rate
FRA start date
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-41
18.7 Forward Rate Agreements (FRAs)
(cont.)
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Slides prepared by Anthony Stanger
18-42
18.7 Forward Rate Agreements (FRAs)
(cont.)
Settlement amount = FRA settlement rate - FRA agreed rate
365  P
365  P


365  (D  i s ) 365  (D  ic )
(18.2)
where :
i s  the FRA settlement rate expressed as a decimal
i c  the contract FRA agreed rate expressed as a decimal
D  the number of days in the contract period
P  the contract notional principal amount.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-43
18.7 Forward Rate Agreements (FRAs)
(cont.)
• Using an FRA for a borrowing hedge
–
Example: On 19 September this year a company wishes
to lock in the interest rate on a prospective borrowing of
$5 000 000 for a 6-month period from 19 April next year to
19 October of the same year. An FRA dealer quotes
‘7Mv13M 13.25 to 20’. On 19 April the BBSW on 180-day
money is 13.95% per annum.
365  P
365  P

365  (D  is ) 365  (D  ic )
where
i s  0.1395 (on 19 April)
i c  0.1325 (19 September)
D  183 days (from 19 April to 19 October)
P  $5 000 000
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-44
18.7 Forward Rate Agreements (FRAs)
(cont.)
• Using an FRA for a borrowing hedge (cont.)
365  5 000 000
365  5 000 000
Settlement 

365  (183  0.1395) 365  (183  0.1325)
 $4 673 154.46 - $4 688 533.65
 - $15 379.19
As interest rates have risen over the period, the settlement
of $15 379.19 is paid by the FRA dealer to the company
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-45
18.7 Forward Rate Agreements (FRAs)
(cont.)
Copyright  2007 McGraw-Hill Australia Pty Ltd
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18-46
18.7 Forward Rate Agreements (FRAs)
(cont.)
• Main advantages of FRAs
 Tailor-made, over-the-counter contract, providing great
flexibility with respect to contract period and the amount of
each contract
 Unlike a futures contract, an FRA does not have margin
payments
• Main disadvantages of FRAs
 Risk of non-settlement (credit risk)
 No formal market exists and concern about difficulty to
close out FRA position is overcome by entering into another
FRA opposite to the original agreement
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-47
Chapter Organisation
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.8
Hedging Using Futures Contracts
Main Features of a Futures Transactions
Futures Market Instruments
Futures Market Participants
Hedging: Risk Management Using Futures
Risks in Using Futures Markets for Hedging
Forward Rate Agreements (FRAs)
Summary
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a McGrath’s Financial Institutions, Instruments and Markets 5e by Viney
Slides prepared by Anthony Stanger
18-48
18.8 Summary
• A futures contract
– Is an agreement between two parties to buy or sell a
specified commodity or instrument at a specified date in
the future, at a price specified today
– May be used as a hedging strategy by opening a position
today that requires a closing transaction that is the
reverse of the exposed transaction in the physical market
– Limitations include margin calls, imperfect hedging due to
basis risk, and availability
Copyright  2007 McGraw-Hill Australia Pty Ltd
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18-49
18.8 Summary (cont.)
• FRAs
– Are over-the-counter contracts specifying an agreed
interest rate to apply at a future date
– Advantages include
 Flexibility—they are tailor-made
 No margin calls
– Disadvantages include
 Non-settlement or credit risk
 Lack of formal market
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18-50