Futures Markets

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Futures Markets

• Riccardo Colacito

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Motivational Example 1

• A farmer grows wheat
• The entire planting seasons revenue depends on
  the highly volatile crops price
• Diversification is not possible
• The farmer would like to lock in a price at which
  deliver the crop

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Motivational Example 2

• A US firm is exporting part of its produced goods
  to the UK in a month
• The goods will be paid in British Pounds and must
  then be converted in US Dollars
• The exchange rate is quite volatile
• The US firm would like to lock in an exchange rate

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Forwards and Futures

• Forward - an agreement calling for a future
  delivery of an asset at an agreed-upon price
• Futures - similar to forward but feature
  formalized and standardized characteristics

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Key difference in futures

• Standardized types of contacts
• Standardized contract units
• Higher Liquidity
• Marked to market
• Clearinghouse warrants performance

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Key Terms for Futures Contracts

• Futures price - agreed-upon price at maturity
• Long position - agrees to purchase
• Short position - agrees to sell
• At the time the contract is entered into, no
  money changes hands

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Profits on positions at maturity

• Long spot minus original futures price
• Short original futures price minus spot
• That is the long position profits from price
  increases!

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Futures vs Options

• The long futures position trader cannot simply
  walk away from the contract
• No need to distinguish between gross payoff and
  net profit,
• Because futures contract is not purchased it is
  simply a contract that is agreed to by two parties

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Figure 16-2 Profits to Buyers and Sellers of
Futures and Options Contracts
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Futures vs Options (contd)

• Remember how the profit profile of an investor
  that buys a call option looks like?
• How does it compare with the payoff of an
  investor holding a long futures position?
• The answer on the set of slides Options Markets!

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Types of Contracts

• Agricultural commodities
• Metals and minerals (including energy contracts)
• Foreign currencies
• Financial futures
• Interest rate futures
• Stock index futures
• Exotic futures www.tradesports.com

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Trading Mechanics

• Clearinghouse - acts as a party to all buyers and
  sellers.
• Long and short traders do not hold contracts with
  each other
• Clearinghouse acts as seller or buyer
• Obligated to deliver or supply delivery
• Only party that can be hurt by failure of any
  trader to respect obligation
• Clearinghouse is neutral it takes a long for
  each short position

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Figure 16-3 Trading With and Without a
Clearinghouse
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Closing out positions

• Almost all traders liquidate their positions
  before the contract maturity date
• This is called reversing the trade
• If a long position wants to close it before
  maturity, instructs broker to enter the short
  side of a contract
• Profits or losses on the contract are realized
• Less than 3 of contracts gets to maturity

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Concept check

• So whats the profit/loss realized by the long
  trader that buys a contract at time 0 and
  reverses it at time t?
• What about the short trader?

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Margin and Trading Arrangements

• Initial Margin funds (cash or T-Bills)
  deposited to provide capital to absorb losses
• Initial Margin is usually between 5 and 15
• Marking to Market - each day the profits or
  losses from the new futures price and reflected
  in the account.

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Margin and Trading Arrangements

• Maintenance or variance margin - an established
  value below which a traders margin may not fall.
• Margin call - when the maintenance margin is
  reached, broker will ask for additional margin
  funds
• Futures follow this pay-as-you-go procedure,
  while forwards are simply held until maturity (no
  funds transferred until then)

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Example futures price of silver
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Daily proceeds
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At Delivery Date

• Convergence of Price - as maturity approaches the
  spot and futures price converge
• Delivery - Actual commodity of a certain grade
  with a delivery location or for some contracts
  cash settlement
• E.g. SP500 futures

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Regulations

• Futures market regulated by the Commodity Futures
  Trading Commission (CFTC)
• May set limits on how much futures price may
  change from day to day
• Limit violent price fluctuations
• Does not always reach this goal

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Trading Strategies

• Speculation
• short - believe price will fall
• long - believe price will rise

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Speculation Example

• You believe that crude oil prices are going to
  increase
• Current futures price is 52.67 per barrel
• Each contract calls for the delivery of 1,000
  barrels
• If crude oil is selling at 54.67 at contract
  maturity, the speculator that entered the long
  side will profit 2,000 per contract!

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Speculator why futures?

• Why is the speculator interested in futures
  rather than in the underlying asset directly?
• Smaller Transaction costs
• Must post margin that is considerably less than
  value of underlying asset (i.e. greater leverage)

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Trading Strategies (contd)

• Hedging insulate against price movements
• long hedge - protecting against a rise in price
• short hedge - protecting against a fall in price

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Hedger Examples

• Oil distributors wants to sell 100,000 barrels of
  Oil in November and wishes to hedge against
  possible decline in price
• Take a short position on the same underlying
• At Delivery he gets PT from oil sale and F0-PT
  from futures
• In other words she always makes F0

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Hedger Examples (contd)

• A power supplier planning to purchase oil is
  afraid that prices might rise by the time of the
  purchase
• Take a long position on oil futures
• At maturity she always makes F0

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Cross hedging

• Exact future hedging may be impossible
• Necessary futures contract may not be traded
• Example
• manager of a diversified portfolio would like
  futures on every single asset that is part of the
  portfolio, but they do not exists
• Solution hedge with index futures highly
  correlated with well diversified portfolio
• Cross hedging hedging a position using futures
  on another asset

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Basis and Basis Risk

• Basis - the difference between the futures price
  and the spot price
• over time the basis will likely change and will
  eventually converge
• Basis Risk - the variability in the basis that
  will affect profits and/or hedging performance

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Speculating on the basis

• Hold 100 ounces of gold
• Short one gold futures contract (based on 100
  ounces)
• Today prices 391 (gold) and 396 (futures)
• Tomorrows prices 394 (gold) and 398.50
  (futures)
• The basis shrinks by 0.50 an ounce net gain!

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Spread (Futures)

• Taking a long position in a futures contract of
  one maturity and a short position in a contract
  at a different maturity both on the same commodity

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Speculating on the spread

• Hold a September maturity contract long
• Hold a June contract short
• Sep futures increases by 5 cents
• June futures increases by 4 cents
• The net gain is 1 cent!

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Futures Pricing

• Spot-futures parity theorem - two ways to acquire
  an asset for some date in the future
• Purchase it now and store it
• Take a long position in futures
• These two strategies must have the same market
  determined costs

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Parity Example Using Gold

• Strategy 1 Buy gold now at the spot price
  (S0) and hold it until time T when it will be
  worth ST
• Strategy 2 Enter a long position in gold
  futures today and invest enough funds in T-bills
  (F0) so that it will cover the futures price of ST

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Parity Example Outcomes

• Strategy A Action Initial flows Flows at T
• Buy gold -So ST
• Strategy B Action Initial flows Flows at T
• Long futures 0 ST - FO
• Invest in Bill
• FO/(1rf)T - FO /(1rf)T FO
• Total for B - FO /(1rf)T ST

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Price of Futures with Parity

• Since the strategies have the same flows at
  time T
• FO / (1 rf)T SO
• FO SO (1 rf)T
• The futures price has to equal the carrying
  cost of the gold

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Example-Futures Pricing

• Gold currently sells for 400 an ounce
• Risk free rate is 0.5 per month
• What is the price of a six month futures contract
  on an ounce of gold?

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The futures price of gold!

• The futures price of gold is

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An Arbitrage Opportunity?

• Suppose that the price of gold futures is 413
  (rather than 412.15, as just computed)
• Can you construct an arbitrage?

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Step 1

• Construct a zero cost position at time 0
• Buy gold for 400
• Borrow at the risk-free rate 400
• Enter short futures position (Fo413) this does
  not cost a dime today!

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Step 2

• Verify that the cash flow at maturity is
  different from zero
• Repay debt -400x(1.005)6-412.15
• Got gold ST
• Close out short futures position 413-ST
• The net profit is 0.85

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Figure 16-4 Gold Futures Prices October 2004
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Extensions of spot-futures parity

• If an asset has a dividend yield of d, the
  futures price is
• In the homework you will be asked to derive this!

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Stock Index Contracts

• Available on both domestic and international
  stocks
• Use a multiplier (see next slide)
• Advantages over direct stock purchase
• lower transaction costs
• better for timing or allocation strategies
• takes less time to acquire the portfolio

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Table 16-2 Stock Index Futures
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Table 16-3 Correlations Among Major US Stock
Market Indexes
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Index Arbitrage

• Exploiting mispricing between underlying
  stocks and the futures index contract
• Futures Price too high - short the future and
  buy the underlying stocks
• Futures price too low - long the future and
  short sell the underlying stocks
• Difficult to do in practice
• Transactions costs are often too large
• Trades cannot be done simultaneously

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Additional Financial Futures Contracts

• Foreign Currency
• Forwards versus futures
• Interest Rate Futures
• Short position gains when interest rate rise and
  bond price falls

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Figure 16-5 Spot and Forward Prices in Foreign
Exchange
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Swaps

• Large component of derivatives market
• Over 100 trillion outstanding
• Interest Rate Swaps
• Currency Swaps
• Example Interest rate swaps based on LIBOR

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Figure 16-6 Interest Rate Swap