Financial Futures Markets

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Financial Futures Markets

• Chapter 13

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Futures and Forward Contracts

• 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
• Size of contract
• Grade of deliverable asset
• Delivery date
• Delivery location
• Key difference in futures
• Standardization
• Secondary trading - liquidity
• Marked to market
• Clearinghouse warrants performance

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Key Terms for Futures Contracts

• Futures price - agreed-upon price at maturity
• Positions
• Long Position agrees to buy (take delivery)
• Short Position agrees to sell (make delivery)
• Profit on positions at maturity
• Profit to Long spot price at maturity -
  original futures price (ST F0)
• Profit to Short original futures price spot
  price at maturity (F0 - ST )
• Zero Sum Game

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Futures and Forward Contracts

• Types of Contracts
• Agricultural commodities
• Metals and minerals (including energy contracts)
• Foreign currencies
• Financial futures
• Interest rate futures
• Stock index futures

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Types of Financial Futures

• Interest rate futures are on debt securities such
  as T-bills, T-notes, T-bonds, and Eurodollar CDs
• Stock index futures are on stock indexes
• Settlement dates are in March, June, September,
  and December
• Most financial futures are traded on the Chicago
  Board of Trade or the Chicago Mercantile Exchange

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Purpose of Trading Financial Futures

• Speculation
• take positions to profit from expected changes in
  the price of futures contract over time.
• Hedge
• take positions to reduce the exposure to future
  movements in interest rates or stock prices.

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Trading Strategies

• Speculation
• long - believe price will rise
• short - believe price will fall
• Hedging
• long hedge - protecting against a rise in price
• short hedge - protecting against a fall in price

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Interpreting Financial Futures Tables

• The Wall Street Journal provides a comprehensive
  summary of trading activity on various financial
  futures contracts
• Example of Treasury bill futures quotations

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Valuation of Financial Futures

• The price of a financial futures contract
  generally reflects the expected price of the
  underlying security as of the settlement date
• As the market price of the financial asset
  changes, so will the value of the contract
• Factors that influence the expected price of the
  asset influence the futures price
• The current price of the asset
• Economic or market conditions
• Impact of the opportunity cost
• Investors who buy stock index futures instead of
  the stock index do not receive any dividends
• Investors who buy stock index futures put up a
  much smaller investment

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Explaining Price Movements of Bond Futures
Contracts

• Participants in the Treasury bond futures market
  closely monitor the same economic indicators
  monitored by participants in the Treasury bond
  market
• Employment
• GDP
• Retail sales
• Industrial production
• Consumer confidence
• Inflation indicators
• Indicators that reflect the amount of long-term
  financing

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Speculating with Interest Rate Futures

• Example T-bill futures
• The position taken depends on interest rate
  expectations
• If interest rates are expected to decline (market
  value of t-bill is expected to increase),
  purchase T-bill futures
• If interest rates are expected to increase
  (market value of t-bill is expected to decrease),
  sell T-bill futures
• The maximum possible loss when purchasing futures
  is the amount to be paid for the securities

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Speculating with Interest Rate Futures (contd)
Payoff from Purchasing Futures
Payoff from Selling Futures
0
0
MV of Futures at Settlement
MV of Futures at Settlement
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Speculating on Increasing Interest Rates

• An investor anticipates that interest rates are
  going to decrease. Consequently, she purchases a
  T-bill futures contract for 94.20 in February. On
  the March settlement date, the T-bill has a
  market price of 94.70. What is the investors
  nominal profit from this strategy?

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Speculating on Decreasing Interest Rates

• An investor anticipates that interest rates are
  going to increase. Consequently, she sells a
  T-bill futures contract for 94.20 in February. On
  the March settlement date, the T-bill has a
  market price of 93.50. What is the investors
  nominal profit from this strategy?

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Closing out positions

• Take or make delivery
• Reversing the trade
• Rather than making or accepting delivery, most
  buyers and sellers take offsetting positions to
  close out the futures contract
• e.g., speculators who purchased T-bond futures
  contracts would sell similar futures contracts by
  the settlement date
• Only about 2 percent of all futures contracts
  actually involve delivery

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Closing Out the Futures Position

• A speculator purchased a futures contract on
  T-bonds at a price of 9012. Two months later,
  the speculator sells the same futures contract in
  order to close out the position. At that time,
  the futures contract specifies 9314 of the par
  value as the price. What is the nominal profit
  from this futures transaction?

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Hedging with Interest Rate Futures

• Short hedge
• To reduce exposure to the possibility of rising
  interest rate
• Long hedge
• To reduce exposure to the possibility of
  declining interest rate
• Cross-hedge
• is the use of a futures contract on one financial
  instrument to hedge a position in a different
  financial instrument

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Bond Index Futures

• A bond index futures contract allows for the
  buying or selling of a bond index for a specified
  price at a specified date
• The CBOT offers Municipal Bond Index (MBI)
  futures
• Based on the Bond Buyer Index of 40 actively
  traded general obligation and revenue bonds

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Stock Index Futures

• A stock index futures contract allows for the
  buying and selling of a stock index for a
  specified price at a specified date
• Available for various stock indexes (see next
  slide)
• Have four settlement dates on the third Friday in
  March, June, September, and December
• The securities underlying the stock index futures
  are not deliverable settlement occurs through a
  cash payment
• The net gain or loss is the difference between
  the futures price when the initial position was
  created and the value of the contract on the
  settlement date

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Stock Index Futures
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Stock Index Futures

• Valuing stock index futures contracts
• The value of a stock index futures contract is
  highly correlated with the value of the
  underlying stock index
• The value of a stock index futures contract
  commonly varies from the value of the underlying
  index
• The price of index futures contracts is driven by
  the underlying asset and the cost of carry (the
  net financing cost to buy the index)
• In general, the underlying security changes by a
  much greater degree than the cost of carry, so
  changes in financial futures prices are primarily
  attributed to changes in the values of the
  underlying securities

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Stock Index Futures

• Speculating with stock index futures
• Stock index futures can be traded to capitalize
  on expectations about stock market movements
• If the market is expected to increase, buy stock
  index futures
• If the market is expected to decrease, sell stock
  index futures

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Speculating with Stock Index Futures

• Jimmy Dean expects the SP 500 index to increase
  in the near future. Thus, Jimmy decides to
  purchase an SP 500 futures contract with a
  December settlement date. The current futures
  price is 1,200. If the futures price rises to
  1,250 by the settlement date, what is Jimmys
  nominal profit?

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Stock Index Futures

• Hedging with stock index futures
• Futures can be used to hedge the market risk of
  an existing stock portfolio
• Sell stock index futures if the existing
  portfolio is expected to decline
• Buy stock index futures if the existing portfolio
  is expected to increase
• The hedging is more effective when the investors
  portfolio is diversified like the SP 500 index.

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Stock Index Futures

• Index Arbitrage
• Index arbitrage involves the buying or selling of
  stock index futures with a simultaneous opposite
  position in the stocks that the index comprise

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Risk of Trading Futures Contracts

• Market risk refers to fluctuations in the value
  of the instrument as a result of market
  conditions
• Basis risk is the risk that the position being
  hedged is not affected in the same manner as the
  instrument underlying the futures contract
• Liquidity risk refers to potential price
  distortions due to a lack of liquidity
• Credit risk is the risk that a loss will occur
  because a counterparty defaults on the contract
• Prepayment risk refers to the possibility that
  the assets to be hedged may be prepaid earlier
  than their designated maturity
• Operational risk is the risk of losses as a
  result of inadequate management or controls

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Institutional Use of Futures Markets
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Globalization of Futures Markets

• Non-U.S. participation in U.S. futures contracts
• U.S. futures are commonly traded by non-U.S.
  financial institutions that maintain holdings of
  U.S. securities
• The CBOT has expanded trading hours to cover
  various time zones
• Foreign stock index futures
• Foreign stock index futures have been created to
  speculate on or hedge against potential movements
  in foreign stock markets
• Futures exchange have been established in
  Ireland, France, Spain, and Italy
• Financial futures on debt instruments are offered
  by the London International Financial Futures
  Exchange (LIFFE), the Singapore International
  Monetary Exchange (SEMEX), and Sydney Futures
  Exchange (SFE)

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Globalization of Futures Markets

• Currency futures contracts
• A currency futures contract is a standardized
  agreement to deliver or receive a specified
  amount of a specified foreign currency at a
  specified price (exchange rate) and date
• Settlement months are March, June, September, and
  December
• Currency futures are used by companies to hedge
  foreign payables or receivables