I.

Futures Market Structure

1.

Afuturescontractisanagreementthatthebuyer
(seller) will accept (make) delivery of a particular
assetonafuturedateatapricepre-determinedtoday.

Example: Entering a December gold futures at

$350/ozentitlesthefuturesbuyertopurchase100oz.
of gold on the December maturity date for $350/oz,
disregardthespotmarketpriceofgoldinDecember.
If the spot price on the maturity date is $370/oz, the
buyerstillpays$350/ozforthegold,makinga$20/oz
profit. On the other hand, if the spot price in
December is $340/oz, the buyer would be losing $
10/ozprofit.

I. Futures Market Structure

Somepointstoknow:

By entering into a futures contract, you know today the price

youwillpayforthepurchaseofgoldinDecember($350/oz).In
suchaway,youhavelockinthepriceforafuturetransaction.

At the time of contract agreement, the contract is typically

designed to be of zero value to either the buyer or the seller.
Thereforenoneofthebuyerorthesellerwillhavetopaytothe
otherpartyforthecontract.

Boththebuyerandtheseller,however,willhavetodepositinto
amarginaccount,whichisusedtoguaranteethefulfillmentof
thecontract.

I. Futures Market Structure

2.

When the forward contract is for a standardized

amount of a carefully defined asset for delivery on a
specific date and subject to the terms and conditions
establishedbytheorganizedmarketonwhichistraded,
it becomes a future contract. Financial futures are
standardizedin

1)assetsbeingexchanged;
2)settlementdates;
3)facevalue;and
4)pricequotation.

I. Futures Market Structure

1)

Assetsbeingexchanged:
The underlying asset: 91-day T-bills for a T-bill futures; Tbonds with 20 years to maturity and an 8% coupon rate for a
T-bond futures; and .999 contents for a gold futures.

2)Settlementdates:
March,June,September,andDecembercycleformoststockindexfutures

3)

Facevalue:
$1m for a T-bill futures
$100,000 for a T-bond futures
(Index)*($500) for a S&P 500 index futures

4)

Pricequotation:
%ofdiscountforshort-termfuturescontracts,suchas8%discountonaT-bill
futures
%ofparforlong-termfuturescontracts,suchasT-bondfuturesarequotedat
96-24

I. Futures Market Structure

3.

Most markets prescribe daily settlement of any

gainsandlossesonthefuturescontracttominimize
theriskofdefaultatitsmaturity.
ThisisalsocalledMarking-to-marketbecause,withdaily

settlementforanygainsorlosses,thevalueofthefutures
positioniskepttoequaltothecurrentmarketvalue.

4.

The existence of organized futures markets

provides a secondary market for the trading of
contracts before maturity. In fact most of contracts
areoffsetbeforetheybecomemature.

I. Futures Market Structure

5.

TypesofOrders:
MarketOrder
LimitedOrder
Stop-lossorder
Spreadorder

I. Futures Market Structure

7.

ForwardContractsvs.FuturesContracts:

Forward

Futures

NatureofTransaction

BothbuyersandsellersareobligatedtoSame
buyorsellagivenamountofanasset
atasetpriceatafuturedate

SizeofContracts

Negotiable

Standardized

DeliveryDate

Negotiable

Standardized

MethodofTransaction

Pricesaredeterminedinprivatebythe PricesaredeterminedbyOpen
buyerandseller
Outcryinaauction-typemarketat
registeredexchange

SecurityDeposit

Veryhigh

Verylow

Regulation

StateorFederallawsofcommerce

CommodityFuturesTrading
Commission
NationalFuturesAssociation
Self-regulationbyexchanges

II. Trading Mechanism

Threestepstoafuturestrading:
1.AgreeingToTrade:createslongandshort

positions.
The role of the Futures Clearing Corporation: The clear

houseiscriticaltothetradingoffuturesbecauseitsettles
andguaranteesthecontracts.Afteracontractisagreedto,
theclearinghouseputsitselfbetweenbuyerandsellerand,
ineffect,becomesthepartytowhomdeliveryismadeand
fromwhomdeliveryistaken.

II. Trading Mechanism

2.

Margin requirements: initial margin and

maintenancemargin.

InitialMargin
Contract
Exchange Multiple Speculator
Hedger
______________________________________________________________________
S&P500
CBOE
$500
$22,000
$9,000
NYSEIndex
NYSE
500
9,000
4,000
MajorMarketIndex
AMSE
250
21,000
7,500
ValueLineIndex
KCBT
500
7,000
5,000
______________________________________________________________________

II. Trading Mechanism

EX

: Suppose an investor purchases one

December 1999 gold futures at $400/oz and the
initial margin 2,000/contract and maintenance
marginis$1,500/contract.Themarginaccountis
marked on a daily basis (daily settlement). The
following table summarizes the changes in the
marginaccountuntilthecloseofthecontract.

II. Trading Mechanism

Day

FuturesPrice

DailyGainorLossCumulativeGain MarginAccount
orLoss

August1

$400

$2,000

August1

397.00

-$300

-$300

1,700

396.10

-90

-390

1,610

398.20

210

-180

1,820

397.10

-110

-290

1,710

396.70

-40

-330

1,670

395.40

-130

-460

1,540

393.30

-210

-670

1,330

393.60

30

-640

2,030

391.80

-180

-820

1,850

10

392.70

90

-730

1,940

11

387.00

-570

-1,300

1,370

12

387.00

-1,300

2,000

13

388.10

110

-1,190

2,110

14

388.70

60

-1.130

2,170

15

391.00

230

-900

2,400

16

391.30

130

-770

2,530

MarginCall

$670

630

II. Trading Mechanism

3.OffsettingContracts:Themajorityof

futurescontractsareoffsetbeforematurity.
Thisisbecauseitiscostlytotakedelivery.

III. Leverage with Futures

Onfuturestrading,theonlyout-of-pocketpayment

isthemargindepositedasasecurityperformance
bond.Nopaymentsarerequiredforthecontract,
norfortheunderlyingassetsuntilthesettlementof
thecontract.Thisprovidesanopportunityfor
leverage.

Thegoldfuturesbuyerisleveraginghis/her$2,000initial

marginintoacontracttobuy100ozofgoldinthefuture,
whichamountsto$40,000intoday'svalue.Thisprovides
20timesleverageascomparetobuyinggoldinthespot
market.Thisleverage,however,increasesthereturn
volatility.Itonlytakesasmallchangeonthegoldprice
towipeoutthe$2,000initialinvestment.

III. Leverage with Futures

Example:
Initialinvestmentrequiredonthegoldfutures=$2,000

Initialinvestmentrequiredforaspotmarketpurchase
=$40,000
SpotPrice SpotMarket
GainorLoss%Return

$420
$410
$400
$390

$380

$2,0005%
$1,0002.5%
00%
-$1,000-2.5%
-$2,000-5%

FuturesMarket
GainorLoss%Return
$2,000100%
$1,00050%
00%
-$1,000-50%
-$2,000-100%

VI. FINANCIAL FUTURES

PRICING
I.

Commodity Futures Prices and the Cost of

Carry:
A.Twoimportantcharacteristicsoffuturesprices:
1.Thefuturespriceofacommodityorasset,F,isgreater

thanthespotprice,P;i.e.,F P.
2.Thefuturespricerisesasthetimetomaturityincreases.
Thesecharacteristicsreflectthecostofcarryfora

futurescontractandillustrateacriticalarbitrage
relation.

VI. FINANCIAL FUTURES

PRICING
Ex:SupposethatthespotpriceofNo.2Wheatin

aChicagowarehouseis300centsperbushel,the
yieldaone-monthT-billis6%,andthecostof
storingandinsuringonebushelofwheatis4cents
permonth.Whatisthepriceofafuturescontract
thathasone-monthtomaturity?

VI. FINANCIAL FUTURES PRICING

Twowaystohavewheatinonemonth:

1.Purchaseaone-monthwheatfuturescontractat$F/bushel:

2.Purchaseinspottodayandcarryitoverforonemonth:

Forthetwoalternativestobeindifferent,twocostswouldhavetobethesame,
i.e.,

$F=305.5or

F=P+C

Costsinonemonth=$F

Costsinonemonth=(300+4)*(1+6%/12)=305.5

VI. FINANCIAL FUTURES

PRICING
Thisisanequilibriumcondition.Itthisisnottrue,

thenmarketadjustmentswillbringbackthe
equilibrium.

IfF>P+C,atradercouldmakearisklessprofitbytaking

alongpositionintheassetandashortpositioninthe
futurescontract.

IfF<P+C,thearbitragestrategywouldbetobuythe

futuresandsellthecommodityshort.

VI. FINANCIAL FUTURES

PRICING
B.Twoimplicationsonthemovementsoffutures

prices:

1.Theconvergenceofthefuturespricetothe
spotpriceisimpliedbythecostofcarryrelation.
2.Theconvergenceofthefuturespricetothe
cashpriceatexpirationofthefuturescontract.

VI. FINANCIAL FUTURES

PRICING
C.DeterminantsoftheBasis(Risk):
1.TheConvergenceoftheFuturePricetotheCash

Price;Ifthefuturepositionisunwindedpriortocontract
maturity,thereturnfromthefuturespositioncoulddiffer
fromthereturnontheassetduetothebasisrisk.

2.ChangesinFactorsAffectingtheCostofCarry;the

mostsignificantdeterminantofthecostofcarryingisthe
interestrate.Astheinterestrateincreases,theopportunity
costofholdingtheassetrises,sothecostofcarry-and
thereforethebasis-rises.

VI. FINANCIAL FUTURES PRICING

3.MismatchesbetweentheExposureBeingHedgedandthe

FuturesContractBeingUsedastheHedge:
Inacross-hedge,thereisanadditionalsourceofbasisrisk.
Basisresultsnotonlyfromdifferencesbetweenthefuturesprice
andtheprevailingspotpriceofthedeliverableasset,butalso
fromdifferencesbetweenthespotPricesofthedeliverableasset
andtheexposurebeinghedged.Majorfactorsresponsiblefor
variationinthebasisforacross-hedge:

(1)Maturitymismatch
(2)Liquiditydifferences
(3)CreditRiskDifferences

4.RandomDeviationsfromtheCost-of-CarryRelation:

"Whitenoises",buttherearecanceledoutinthelongrun.

VI. FINANCIAL FUTURES

PRICING
II.

Futures Prices and Expected Futures Spot Prices

Theexpectationmodelstatesthatthecurrentfuturespriceisequal
tothemarket'sexpectedvalueofthespotpriceatperiodT:
Ft=E(PT)

Ifthismodeliscorrect,aspeculatorcanexpectneithertogainnor

tolosefromapositioninthefuturesmarket:
E(Profit)=E(PT)-FT=0

VI. FINANCIAL FUTURES

PRICING
EX:Supposethatattimeperiod0,aspeculator

purchasesafuturescontractatapriceofF,andposts
100%marginintheformofrisklesssecurities.

AtcontractmaturityT,thevalueofthemarginaccount
willhavegrowntoF0*(1+rf)
Atmaturity,thevalueofthefuturescontractitselfwill

be:(PT- F0).

VI. FINANCIAL FUTURES PRICING

Theactualrateofreturnthespeculatorwillearnis

(1+rf)F0 +(PT-F0)

(PT-F0)

r=

----------------------------1=rf +--------

F0 F0

Theexpectedrateofreturnris

E(PT)-F0

E(R)=rf +

-------------=rf

F0

Iftheexpectationmodeliscorrect.

V. Financial Futures: Interest Rate

Futures as a Hedging Device
Hedging

Principle:

To

hedge against falling interest rates or rising

prices (on a spot position), take a long position by
buying futures

To

hedge against rising interest rates or falling

prices (on a spot position), take a short position by
selling futures

V. Financial Futures: Interest Rate

Futures as a Hedging Device
Long

Hedging:

value
Futurespositionvalue

gain
0

Spotprice

loss
Spotpositionvalue

V. Financial Futures: Interest Rate

Futures as a Hedging Device
I.

Long Hedge
Alonghedgeischoseninanticipationofinterestrate
declinesandrequiresthepurchaseofinterestratefutures
contract.Iftheforecastiscorrect,theprofitonthehedge
helpstooffsetlossesinthecashmarket.
Example:InApril2005,themanagerofamoneymarket
portfolioexpectsinterestratestodecline.Newfunds,tobe
received&investedin90days,willsufferfromthedropin
yields.Themanagerexpectsaninflowof$10minJuly.The
discountyieldcurrentlyavailableon91-dayT-billsis10%,
andthegoalistoestablishayieldof10%ontheanticipated
funds.

V. Financial Futures: Interest Rate Futures

as a Hedging Device
CashMarket
FuturesMarket
___________________________________________________________________

April:T-billdiscountyieldat10%
April:buy10T-billContractsfor
Priceof91-dayT-bills,Septemberdeliveryat10%discount
$10mpar=$9,747,222 yield.Valueofcontracts=$9,750,000

July :T-billdiscountyieldat8%
July:Sell10Sept.T-billcontracts
Priceof91-dayT-bills,
at8%discountyield.
$10mpar=$9,797,778
Valueofcontracts=$9,800,000
_______________________________________________________________________
OpportunityLoss Gain=$50,000
=$50,556
EffectiveDiscountYieldwiththeHedge

$10,000,000-($9,797,778-$50,000)
= --------------------------------------------*
$10,000,000
91

360
----

=9.978%

V. Financial Futures: Interest Rate Futures

as a Hedging Device
Eveniftheexpectationonfutureinterestratesforthe

cashmarketisincorrect,thepositionisstillhedged.The
costisthatthepotentialprofitableopportunitiesinthe
cashmarketisforegone.

EX;AssumetheT-billdiscountyieldrisesto12%,insteadofdecliningto8%asexpected.

CashMarket
FuturesMarket
_______________________________________________________________________
April:T-billdiscountyieldat10%
April:Buy10T-billContractsfor
Priceof91-dayT-bills,
Septemberdeliveryat10%discount
$10mpar=$9,747,222
yield.Valueofcontracts=$9,750,000

July:T-billdiscountyieldat12%
July:Sell10Sept.T-billcontracts
Priceof91-dayT-bills,
at12%discountyield.
$10mpar=$9,696,667
Valueofcontracts=$9,700,000
_______________________________________________________________________
Opportunitygain
Loss=$50,000
=$50,555

V. Financial Futures: Interest Rate Futures

as a Hedging Device
Long

speculation:Insteadofexpectingnewfundsto
arrive&investinJuly,themanagercouldspeculateon
thedirectionofinterestrates.Ifhe/shespeculatesona
declininginterestrate,andthespeculationis
materialized:

CashMarket
FuturesMarket
_______________________________________________________________________
April:T-billdiscountyieldat10%
April:buy10T-billContractsfor
Priceof91-dayT-bills,Septemberdeliveryat10%discount
$10mpar=$9,747,222 yield.Valueofcontracts=$9,750,000

July:T-billdiscountyieldat8%
July:Sell10Sept.T-billcontracts
Priceof91-dayT-bills, at8%discountyield.
$10mpar=$9,797,778
Valueofcontracts=$9,800,000
_______________________________________________________________________
Gain=$50,000

V. Financial Futures: Interest Rate

Futures as a Hedging Device
Ifhe/shespeculatesonadeclininginterestrate,but

marketraterisesinSeptemberinstead:

CashMarket
Futures
Market_______________________________________________________________________
April:T-billdiscountyieldat10%
April:Buy10T-billContractsfor
Priceof91-dayT-bills, Septemberdeliveryat10%discount
$10mpar=$9,747,222 yield.Valueofcontracts=$9,750,000

July:T-billdiscountyieldat12%
July:Sell10Sept.T-billcontracts
Priceof91-dayT-bills, at12%discountyield.
$10mpar=$9,696,667 Valueofcontracts=$9,700,000
_______________________________________________________________________

Loss=$50,000

V. Financial Futures: Interest Rate

Futures as a Hedging Device
II.

Short Hedge:
Ashorthedgeischoseninanticipationofinterestrate
increasesandrequiresthesaleofinterestratefutures.
Iftheforecastiscorrecttheprofitonthehedgehelpsto
offsetlossesinthecashmarket.

V. Financial Futures: Interest Rate

Futures as a Hedging Device
Example:AsavinginstitutioninApril2005wantsto

hedge$5minshort-termCDswhoseownersare
expectedtorollthemoverin90days.Ifmarketyields
goup,thethriftmustofferahigherrateonitsCDsto
remaincompetitive,reducingthenetinterestmargin.If
theCDrarerisesfrom7%to9%,theinterestcostwill
increaseby$25,000forthe3-monthperiod.The
asset/liabilitymanagercanreducethesebythesaleof
T-billfuturescontracts.

V. Financial Futures: Interest Rate Futures

as a Hedging Device

CashMarket
FuturesMarket
_______________________________________________________________________
April.:CDrate=7%
April.:Sell5Sept.T-billcontractsat
interestcoston$5m3-month
7%discountyield
interestcosts=$87,500
Valueofcontract:$4,912,500

July:CDrate=9%
July:Buy5Sept.T-billcontractsat
interestcoston$5m3-month
9%discount
deposits
Valueofcontracts=$4,887,500
=$112,500
______________________________________________________________________
OpportunityLoss =$25,000 Gain=$25,000

Netresultofhedge=0

EffectiveCDRate=

5,000,000

$112,500-$25,000 360
----------------------* ----90

=7%

V. Financial Futures: Interest Rate

Futures as a Hedging Device

Basis Risk Using the Long Hedge Example

Long Hedge Example as previously stated:

CashMarket

FuturesMarket

___________________________________________________________________

April:T-billdiscountyieldat10%
April:buy10T-billContractsfor
Priceof91-dayT-bills,Septemberdeliveryat10%discount
$10mpar=$9,747,222
yield.Valueofcontracts=$9,750,000

July :T-billdiscountyieldat8%
July:Sell10Sept.T-billcontracts
Priceof91-dayT-bills,
at8%discountyield.
$10mpar=$9,797,778
Valueofcontracts=$9,800,000
_______________________________________________________________________
OpportunityLoss =$50,556
Gain=$50,000

EffectiveDiscountYieldwiththeHedge

$10,000,000-($9,797,778-$50,000)
=
--------------------------------------------*

360
----

=9.978%

V. Financial Futures: Interest Rate

Futures as a Hedging Device

RevisedExample:RatherthanusingT-billcontractforhedging,a
long-termT-bond futurescontractisusedforhedgingwhichis
priceat96-12.IftheT-billratedropsto8%inSeptemberas
expected,theT-bondfutureswillhaveitpriceincreasedto98-16.

CashMarket
FuturesMarket
_______________________________________________________________________
April:T-billdiscountyieldat10%
April:Buy100T-bondContractsfor
Priceof91-dayT-bills, Septemberdeliveryat96-12which
$10mpar=$9,747,222 givesthevalueofcontracts=$9,637,500

July:T-billdiscountyieldat8%
July:Sell100Sept.T-bondcontracts
Priceof91-dayT-bills, at98-16foravalue$9,850,000
$10mpar=$9,797,778
_______________________________________________________________________
OpportunityLoss Gain=$212,500
=$50,556

VI. Macrohedging with Futures for

a Financial Institution
SupposeaFI'sbalancesheetstructureisas

follows:Assets=$100m,Liabilities=$90m,and
equity$10m.Theaveragedurationofassetsand
liabilitiesis5and3years,respectively.Ifinterest
ratesareexpectedtorisefrom10%to11%,then:

E=(DA-kDL)*A*( R/1+R)
=-(5-.9*3)*$100m*(.01/1.1)=-$2.09m

VI. Macrohedging with Futures for

a Financial Institution
Themanager'sobjectiveistofullyhedgethebalance

sheetexposurebyconstructingafuturespositiontomake
againtojustoffsetthelossof$2.09monequity.

Wheninterestratesrise,thepriceoffuturescontracts
falls.Thesensitivityofthepriceofafuturescontracts
dependsonthedurationofthedeliverablebond
underlyingthecontract,or:
F/F
=-DF*( R/1+R),or

=-DF*F*( R/1+R)
=-D*(NF*PF)*( R/1+R)

VI. Macrohedging with Futures for

a Financial Institution
Fullyhedgingcanbedefinedassellingsufficientnumberof

futurescontractssothatthelossofnetworthonthebalance
sheetisjustoffsetbythegainfromoff-balance-sheetsellingof
futures:

F= E
whichimplies:
NF =[(DA-kDL)*A]/DF *PF
=[(5-.9*3)*$100m]/(9.5*$97,000)
=249.59contracts
ifaT-bondfuturescontractisusedforhedging.Thefuturesis

quoted$97per$100offacevalueforthebenchmark20-yr.,8%
couponbondthathasadurationof9.5yrs.

VI. Macrohedging with Futures for

a Financial Institution
Supposeinsteadofusingthe20-yr.T-bondfuturesto
hedgeithadusedthe3-monthT-billfuturesthathasa
priceof$97per$100parvalueandadurationof.25yrs.
Then

NF=(5-.9$3)$100m/.25*$97,000=948.45contracts

IngeneralfewerT-bondcontractsneedtobesoldbecause
ofitsgreaterinterestratesensitivity.Thissuggestsa
simpletransactioncostbasis,theFImightnormallyprefer
touseT-bondfutures.

VI. Macrohedging with Futures for

a Financial Institution
TheProblemofBasisRisk:

Becausespotbondsandfuturesonbondsaretradedin

differentmarkets,theshiftinyields( R/1+R)affecting
thevalueoftheon-balance-sheetcashportfoliomay
differfromtheshift( RF/1+RF)inyieldsaffectingthe
valueoftheunderlyingbondinthefuturescontracts;i.e.,
spotandfuturespricesorvaluesarenotperfectly
correlated.Totakethisbasisriskintoaccount:
E=-(DA-kDL)*A*( R/1+R)

F=-DF*(NF *PF )*( RF/1+RF)

VI. Macrohedging with Futures for

a Financial Institution

Setting: E= F,wehave
NF=[(DA-kDL)*A]/DF*PF*b,

Whereb=( R/1+R)/( RF/1+RF)

wherebmeasuresthedegreetowhichthefuturespriceyields
movemoreorlessthanspotpriceyields.Forexample,ifb=
1.1,thisimpliesthatforevery1%changeindiscountedspot
rate( R/1+R),theimpliedrateonthedeliverablebondinthe
futuresmarketmovesby1.1%.
NF=(5-.9*3)*$100m/9.5*497,000*1.1

=226.9contracts

VII. Risks In Futures

Transactions
1.

Basisrisk:The"basis"isdifferencebetweenthespot
priceofaninstrumentandthepriceofthatassetinthe
futuresmarket.Basicriskresultsfromthefactthatthis
pricerelationshipmaychangeovertime.Howeverthis
basisriskisstableandpredictable.

2.

Related-ContractRisk:Hedgescanalsofailbecause
ofdefaultinthecontractbeinghedged.

VII. Risks In Futures

Transactions
3.

ManipulationRisk:Mostmanipulationinvolved"short
Squeezes"'wherebyanindividualofgrouptriestomakein
difficultonimpossibleforshortsellersinthefutures
marketstoliquidatetheircontractsthroughdeliveryof
acceptablecommodities.The"short"willhavetobuyback
theircontractsasinflatedprices.
4. MarginRisk:Anilliquidindividualcanalsoencounter
difficultybyhedginginthefuturesmarketsifthefuture
pricesmovesadverselyandtheindividualmustconstantly
posemoremaintenancemarginfunds.