Week 10 Futures and Forwards

True/False Questions
1. Derivatives are products that enable the management of risks associated with interest rates,
exchange rates, stock prices and commodity prices.
True, Financial derivative contracts enable investors and borrowers to protect assets, liabilities and
associated cash flows against the risk of changes in interest rates, exchange rates and share prices.

2. A futures contract is a derivative product that is traded over the counter with a financial institution.
False, A futures contract is a legally binding agreement between two parties to buy, or sell, a specified
commodity or financial instrument at a specified date in the future at a price determined today.

3. A financial futures contract allows a hedger to create a situation where any change in the physical
market price of a financial instrument is mostly offset by a profit, or loss, derived from the futures
market transactions.
True, a hedger, can use a futures contract to create a situation in which any change in the physical
market price of a commodity or financial instrument is offset by a profit or loss derived from a
corresponding change in the value of a futures contract risk management strategy.

4. A limit order is one in which a client instructs the broker to buy a specific contract only up to a
specified price or to sell a specified contract down to a specified price.
True, a limit order is an order to buy at the lowest price up to a specified limit, or to sell at the highest
price down to a specified limit.

5. An opening position in the futures market requires an initial margin to be lodged with the futures
exchange clearing house.
True, when opening a position in the futures market, parties are only required to pay a deposit or
initial margin.

6. Margin calls are normally made once a week, since all contracts are marked-to-market at the end
of each week.
False, margin calls could be made daily since future contracts are marked-market on a daily basis.

7. A client with a long position in a 90-day bank-accepted bill futures contract would experience a
reduction in the balance of their margin account if the price of the contract fell from 92.50 to 91.50.
True, a client would have their margin account debited if the price of the contract fell from 92.50 to
91.50.

Week 10 Futures and Forwards

True/False Questions
8. If an investor has a long position in three-year Treasury bond futures contracts, on the delivery date
the investor must deliver the specified Treasury bonds to ASX Trade 24.
True, if an investor has a long position, final settlement may be in the form of delivery of the actual
underlying financial instrument, known as standard delivery.

9. A borrower with a short position in an interest rate futures contract can close out the futures
position by establishing a long position in the same contract with the same delivery date as the
original contract.
True, a borrower is able to close out their open positions at any time by conducting an opposite
futures contract transaction with an identical delivery date.

10. The main participants in the futures markets are parties that hedge a risk exposure associated
with an underlying physical market product. As such, speculators do not participate in the futures
market.
False, the main participants are hedgers, speculators, traders and arbitrageurs.

11. A business that intends to obtain funds through the sale of bank-accepted bills at a known future
date can hedge the risk that yields will change between now and the issue date by buying the
appropriate number of futures contracts now.
True, by buying the appropriate number of futures contracts now, a business that intends to obtain
funds through the sale of bank-accepted bills at a known future date can hedge the risk that yields will
change between now and the issue date.

12. If a short bank-accepted bills futures position is opened at 92.50, and is closed out at 93.50, a
loss would be made through the futures market transactions.
False, if the short bank accepted bills were opened at 92.50 and closed at 93.50 a profit would have
been made.

13. A share portfolio manager is to use futures contracts to hedge the value of a diversified share
portfolio against a fall in share prices. The manager will sell the appropriate number of related share
price index futures contracts now.
True, An investor who holds a share portfolio, or intends to purchase shares in the future, is exposed
to changes in share prices over time. An investor may decide to use a contract offered on a futures
exchange, such as ASX Trade 24, to hedge this risk.

Week 10 Futures and Forwards

True/False Questions
14. It would be impossible to obtain a perfect interest rate hedge on bank bills currently yielding 7.25
per cent per annum in the physical market if the bank bill futures contracts are currently priced at
92.40.
True, It is generally not possible to obtain a perfect hedge because prices often vary between the
cash market and the futures market. This occurs because market participants have already begun to
build an expectation of an interest rate rise into the price of the futures contract.

15. Basis risk is the difference between the initial price of a futures contract and the final price of the
same contract.
False, basis risk describes the difference between the price of a commodity or financial instrument in
the physical market and the price of the related futures contract.

16. Cross-commodity hedging risk occurs because futures contracts are not available on all financial
assets, and so the hedger may need to use a futures contract that approximates the physical market
asset that is at risk.
True, Cross-commodity hedging occurs when a hedging strategy uses a futures contract based on
one underlying asset to hedge a risk associated with a different asset. The necessity for crosscommodity hedging occurs because each futures exchange offers only a relatively small number of
futures contracts that are based on a limited range of commodities and financial instruments.

17. The FRA market trades in interest rate contracts that are highly standardised in amounts and
delivery dates.
False, An FRA is a non-standardised contract typically offered by commercial banks and investment
banks; that is, it is a contract where it is possible to negotiate specific terms and conditions to meet
the particular risk management needs, for example the term and the amount of the FRA.

18. FRA transactions can be used to lock in a future cost of funds; they also guarantee the availability
of funds for a borrower at a specified future date.
False, while the FRA is a contractual agreement between two parties that effectively allows the
parties to lock in a rate of interest that will apply at a specified future date, the agreement relates to
the interest rate only; no exchange of principal takes place.

19. If a company receives a quote from an FRA dealer of 2Mv5M(6) 9.35 to 20, it would be able to
use an FRA to lock in a future cost of borrowing at 9.20 per cent per annum.
False, the quote means in two months time it would be able to borrow at 9.35 per cent per annum or
lend at 9.20 per cent per annum.

Week 10 Futures and Forwards

True/False Questions
20. A borrowing hedge using an FRA is based on a notional principal amount. If the reference rate
rises above the FRA agreed rate, the writer of the FRA will pay a compensation amount to the hedger.
True, if the reference rate rises above the FRA agreed rate, the writer would compensate the hedger.

Essay Questions
2. Define a futures contract. Describe the basic principles behind the use of futures contracts to
manage risk exposures.
A futures contract is a legally binding contract between two parties to buy or sell a specified
commodity or financial instrument at a specified future date at a price determined today. Futures
contracts are essentially designed to allow the management of certain risks attached to commodities
and financial instruments.
The price of a futures contract is calculated using the underlying physical market asset price formulae,
such as the bond formula and the discount security formula.
Transactions are recorded by the exchange's clearing house; buying a futures contract is a long
position, selling is a short position. A futures contract requires payment of an initial margin to the
clearing house. Contracts are marked-to-market (re-priced) each day. Adverse price movement will
require a maintenance margin call.
The majority of futures contracts are closed out by buying or selling an identical contract before the
original contract expiry date. Settlement of a futures contract may be by standard delivery (limited to
certain contracts) or by cash settlement.

4.
(a) Outline the procedure involved in buying a futures contract.
A market order will be placed with a broker to buy or sell a particular contract. Transactions are then
conducted by open outcry on the exchange floor (for example, CBOT) or on the exchanges electronic
trading platform. The electronic trading system automatically matches buy and sell orders. Details of
the transaction are entered with the SFE clearing-house.
The full futures contract price is not paid; rather an initial margin is deposited with the clearing-house.
The margin is sufficient to cover immediate adverse movements in contract prices in case it is
necessary for the clearing-house to close out a position for a client. The clearing-house will mark to
market the contract daily.

(b) Indicate the implications of being long in a futures contract.

A long position occurs when the underlying asset has been bought forwardthat is, a buy futures
contract.

(c) Indicate the implications of being short in a futures contract.

Being short in a futures contract would mean that one contracted to an agreement to sell.

Week 10 Futures and Forwards

True/False Questions
4.
(d) What are the procedures for closing out these positions prior to delivery?
For a company to close out its position, it would instruct its broker to enter into a contract that is
exactly the opposite in direction, but identical in delivery date, to that of its initial futures contract.

6. A funds manager that has sold a 10-year Treasury bond futures contract has not closed out its
position by delivery date. What procedure must be followed to settle the open position? (LO 19.2)
ASX Trade 24 requires that financial futures positions that are still in existence at the close of trading
in the contract month be settled with the clearing house. Depending on the particular futures contract,
final settlement may be in the form of delivery of the actual underlying financial instrument, known as
standard delivery, or may be by cash settlement.
If the open position has not been closed out by the expiry date then SFE clearing-house will close out
the position by taking an opposite contract.
The clearing-house will calculate the net differential between the two contracts and will subtract any
loss on the contract from the margin being held. The balance will be forwarded to the broker of the
client. If a profit has been made from the two contracts, then this will be sent to the broker of the client
along with the margin being held.

8. A business plans to borrow approximately $20 million in short-term funding through the issue of
commercial paper in three months time. The business does not have a view on what is likely to
happen to interest rates over the next three months, but it would be very satisfied if it could obtain its
funding at the current yield.
(a) Using the following data, show how 90-day bank-accepted bills futures contracts can be used to
hedge the interest rate risk to which the business is exposed. Show the calculation and timing of all
transactions and cash flows (ignore transaction costs and margin requirements).
Today's data:
(i) Current commercial paper yields 8.00 per cent per annum
(ii) 90-day bank-accepted bills futures contract 91.75.
Cash or physical market

Futures market

Today:

Today:

The company expects to borrow $20 million

in three months; it notes that current yields
are 8.00%, but is exposed if yields rise before
the commercial paper is issued

Sell twenty 90-day bank-accepted bills

futures contracts at 91.75 (yield 8.25%)
Use discount securities formula:

P=19.613m.

( 365 $ 20,000,000 )
365+ ( 0.0825 90 )

= $19,601,262.00
Pay initial margin

Week 10 Futures and Forwards

True/False Questions
8.
(a)
Data in three months:
(iii) Commercial paper yields 9.00 per cent per annum
(iv) 90-day bank-accepted bills futures contract 91.25
Three months time:

Three months time:

Sell commercial paper with a face value of

$20 millionyield 9.00%

Buy twenty contracts at 91.25

P = $19,577,606.44

P = $19,565,800.05
Hedge outcome:

Cost of borrowing increased over threemonth period by $47,311.18

Profit received from futures transactions
is $23,655.56
Borrower was not able to perfectly hedge
risk because of initial and final basis risk

Profit received from the futures

transactions is $23,655.56
Profit is used to offset the additional cost
of borrowing in the physical market when
the company issues commercial paper
No perfect hedge, since using bank bills
to hedge commercial paper, difference in
yields, basis risk exists, therefore cant
be perfect

(b) What is the effective cost of funds achieved with this hedging strategy? What would the cost of
funds have been had the hedge not been put in place? Explain your answer, showing your
calculations. (LO 19.5)

Effective cost of funds

net cost of funds

365

total amount available 90

434,199.9523,655.56
=8.4994 per annum
19,565,800.05+23,655.56

cost of billsfutures profit

365

amount borrowed+ futures profit 90

10. A funds manager currently manages a diversified Australian share portfolio valued at $25 million.
The manager decides to use the S&P/ASX 200 Index futures contract to manage an exposure to a
forecast decline in share prices. The S&P/ASX 200 Index is currently at 4500. In three months time
the S&P/ASX 200 is at 4265.
(a) Today: set up a hedging strategy to manage the risk exposure.
The price of the share price index (SPI) futures contract equals the S&P/ASX200 index multiplied by
25. With the given share portfolio, the funds manage will sell 222 future contracts.

Value=222 4500 $ 25=$ 24,975,000

Since the manager wishes to protect a selling position in the future, they will sell futures contracts
today. Upon selling the contract, the funds manager would pay an initial margin.

Week 10 Futures and Forwards

True/False Questions
10.
(b) In three months time: close out the open position.
To close an open position, the funds manager must enter into a contract that is exactly the opposite in
direction, but identical in delivery date, to that of its initial futures contract.
In this case, this would mean buying 222 futures contracts. Upon this, the funds manager would
receive a return of their margin payment and future strategy profits.

(c) Show the net valuation effect of the hedging strategy.

In 3 months time, the manager would then buy 222 futures contracts.

Value=222 4265 $ 25=$ 23,670,750

Net profit =$ 24,975,000$ 23,670,750=$ 1,304,250
Therefore the net profit would be used to offset the loss in the share portfolio market.

12. While financial futures contracts may be used to hedge the risk of fluctuations in the prices of the
underlying securities, the use of futures contracts often entails some risk. What are the sources of risk
arising from the use of futures contracts in risk management? List, explain and demonstrate the
implications of each type of risk.
Important risks associated with using futures contracts are:
-

Standard contract sizes

o With an exchange-traded contract it is not possible to change the contract specifications
to meet non-standard risk management needs.
o It is sometimes not possible to match exactly the actual share-market exposure with the
futures market position.
o As a result of this mismatch, a perfect hedge is not possible and there will be a net loss
Margin risk
o If prices move adversely over the period of a futures contract, there will be maintenance
margin calls to be met, involving further cash flows.
o If the contract holder fails to meet a margin call, the futures exchange clearing house will
automatically close out the open position.
Basis risk
o Basis risk describes the difference between the price of a commodity or financial
instrument in the physical market and the price of the related futures contract.
o Price differentials are often evident between the futures market contract price and the
physical market price.
o Initial basis risk occurs at the commencement of a futures hedging strategy.
o Final basis risk may be evident when closing out an open position.
o Basis risk means that a hedger is unlikely to be able to obtain a perfect hedge using a
futures strategy.
Cross-commodity hedging
o The necessity for cross-commodity hedging occurs because each futures exchange offers
only a relatively small number of futures contracts that are based on a limited range of
commodities and financial instruments.

This occurs if there is no futures contract based on the underlying asset that needs to be
hedged.

Week 10 Futures and Forwards

True/False Questions
14.
(a) What is a forward rate agreement?
A forward rate agreement (FRA) is an over- the-counter contract which is specifically designed to
manage interest rate risk exposures. An FRA is a non-standardised contract typically offered by
commercial banks and investment banks; that is, it is a contract where it is possible to negotiate
specific terms and conditions to meet the particular risk management needs, for example the term and
the amount of the FRA.

(b) What are the main features of an FRA? Explain how a corporation that needs to borrow funds in
seven months can use an FRA to fix the cost of funds today.
The main features of an FRA include:
-

The trade or contract datethe date on which the two parties enter into the FRA.
The notional principal amountthe amount upon which the interest rate differential will be
calculated at the end of the contract.
The contract periodon which the FRA interest rate will be based.
The FRA agreed ratethe actual interest rate stipulated in the FRA at the commencement of the
contract.
The FRA settlement reference ratethe published interest rate against which the FRA agreed is
benchmarked and upon which compensation is calculated.
The FRA start datethe date on which the contract period starts. For example, if the FRA is
based on a six-month rate, commencing in seven months (7Mv13M), then the start date is
in seven months time.

(c) What are the main differences between an FRA and a futures contract? (LO 19.7)
FRA
Over-the-counter
Non-standardised, negotiated to meet specific
needs
Doesnt require margin payments
Counter party risk

Futures Contract
Exchange traded
Standardised
Requires margin payments
Guaranteed by the clearing house