[L 9: Financial future markets: Background, valuation of financial futures, price

movement of bond future contract, hedging & speculation, Risk of trading future
contracts]
Financial Future Market
Financial future market have the potential to generate large return to speculators
and they entail a high degree of risk. However, these markets can also be used to
reduce the risk of financial institutions and other corporations. Financial future
markets facilitates the trading of financial future contracts.
What is futures contract
A futures contract is an agreement that requires a party to the agreement either to
buy or sell something at a designated future date at a predetermined price.
Financial futures contracts are highly standardized forward contracts traded on
organized exchanges subject to specific rules.
Financial Futures Contracts Specify
1. Type of security to be traded
2. Delivery Location
3. Amount to be Delivered
4. Date
5. Price
Futures contracts are categorized as either commodity futures or financial
futures. Commodity futures involve traditional agricultural commodities (such as
grain and livestock), imported foodstuffs (such as coffee, cocoa, and sugar), and
industrial commodities. Futures contracts based on a financial instrument or a
financial index are known as financial futures. Financial futures can be classified as
1) stock index futures
2) interest rate futures
3) currency futures.
Futures are a derivative security
Derivatives
Securities whose value is derived from the value of some underlying asset
or financial instrument
Derivative security prices related to factors affecting prices in the spot
market
For example, bond futures prices are related to what is happening in
markets where bonds are bought and sold for immediate delivery

Standardized agreement to deliver or take delivery of a financial instrument at

a specified price and date

Price is determined by traders for standardized contracts

The underlying financial instrument
Settlement date
Form of delivery for underlying asset
Trading on organized exchanges provides liquidity and guaranteed settlement

Derivatives and Spot Prices

Derivative
A security whose value depends on the values of other underlying securities
(also know as contingent claims)
Spot Price
Rate or price quoted for delivery in one or two business days from the date of the
transaction
Derivative Securities
Forward Contracts -- A forward market is a market in which a
commodity/exchange rate for a future exchange of commodities or financial
contracts is fixed today.
Futures Contracts -- An agreement reached at one point in time calling for the
delivery of some commodity at a specified later date at a price established at
the time of contracting.
Options Contracts -- The right (but not the obligation) to buy or sell a
particular good at a specified price
Swap Contract An agreement where two parties agree to exchange periodic
cash flows.
Steps Involved in Trading Futures
Establish account and initial margin
Maintenance margin and margin call
Order to trading floor
Open outcry trading
Clearinghouse function
Daily market-to-market of contracts
Purpose of Trading Financial Futures:

To Speculate
-Take a position with the goal of profiting from expected changes in the
contracts price
-No position in underlying asset
To Hedge
-Minimize or manage risks
-Have position in spot market with the goal to offset risk

Hedging versus Speculating

Hedging -- Hedging is typically defined as utilizing financial instruments or
contracts to reduce or eliminate the risk from future changes in rates or
prices. The purpose of hedging a transaction is to replace an uncertain future
cash flow, rate, or price, with a fixed and certain cash flow, rate, or price
Micro hedging -- Using futures (forward) contract to hedge a specific
asset or liability
Macro hedging -- Hedging the entire exposure of an FI
Routine Hedging versus Selective Hedging
Routine Hedge -- Seeking to hedge all exposure
Selective Hedge -- Only partially hedging the gap or hedging
occasionally

Speculating - In contrast to hedging, the purpose of speculation is to profit

from a change in a future rate or price. Speculating involves the assumption
of additional risk

Why Hedges are Imperfect

Amount - Since exchange traded derivatives have specified contract amounts,
if the amount that we wish to hedge is not exactly equal to some multiple of
the contract size, we must choose to either under-hedge or over-hedge.
Delivery Date - If the date of our future transaction does not perfectly match
with the derivative delivery date, we must choose a contract with a longer
delivery date and close it (Future and spot rates converge as they get closer to
maturity, therefore the correlation between the future and spot rate is not
equal to 1.) out early or an earlier delivery date and remain un-hedged for a
period of time.
Basis Risk When price movements on the futures contract and the
underlying asset are not perfectly correlated, an imperfect hedge results, even
though they are the same asset. This risk can be estimated by obtaining the
correlation between the two prices from past price movements.
Cross-hedging Risk - When we try to hedge an asset with a similar, but not
identical asset. For example, hedge platinum with a gold futures contract.
While historically highly correlated, there is the risk that these past price
patterns
may
not
continue.
Maturity of Contract Security -- For interest rate derivatives, if the item we are
hedging does not have the same maturity of the item that we are using to
hedge the instrument, we are exposed to risk.
Transaction Costs - Commissions and margin requirements take up cash and
make it difficult to get a perfect hedge.

FUTURES VERSUS FORWARD CONTRACTS

A forward contract, just like a futures contract, is an agreement for the future
delivery of something at a specified price at the end of a designated period of time.
Standardized contract
(delivery
date,
quality,
quantity)
Where to be traded
(primary market)
Credit risk (default risk)
Clearing house
Settlement
Transaction cost
Regulation

Future Contracts
Yes

Forward Contracts
No

Organized exchange

Over
the
counter
instrument
Yes
No
End of the contract

No
Yes
Market-to-market
(daily)
Low
High

High
Low

RISK AND RETURN CHARACTERISTICS OF FUTURES CONTRACTS

Long futures: An investor whose opening position is the purchase of a
futures contract

Short futures: An investor whose opening position is the sale of a futures

contract.
The long will realize a profit if the futures price increases.

The short will realize a profit if the futures price decreases.

Pricing of futures contracts

To understand what determines the futures price, consider once again the
futures contract where the underlying instrument is Asset XYZ. The following
assumptions will be made:
1. In the cash market Asset XYZ is selling for $100.
2. Asset XYZ pays the holder (with certainty) $12 per year in four quarterly
payments of $3, and the next quarterly payment is exactly 3 months from
now.
3. The futures contract requires delivery 3 months from now.
4. The current 3-month interest rate at which funds can be loaned or borrowed is
8% per year.
What should the price of this futures contract be? That is, what should the
futures price be? Suppose the price of the futures contract is $107. Consider this
strategy:

Sell the futures contract at $107.

Purchase Asset XYZ in the cash market for $100.
Borrow $100 for 3 months at 8% per year.

1. From Settlement of the Futures Contract

Proceeds from sale of Asset XYZ to settle the
futures contract
=
Payment received from investing in Asset XYZ
for 3 months
=
Total proceeds
2. From the Loan
Repayment of principal of loan
=
Interest on loan (2% for 3 months)
Total outlay
=
Profit
=

$107
$3
= $110
$ 100
=2
$102
$8

Theoretical Futures Price Based On Arbitrage Model

We see that the theoretical futures price can be determined based on the following
information:
1. The price of the asset in the cash market.($ 100)
2. The cash yield earned on the asset until the settlement date. In our example,
the cash yield on Asset XYZ is $3 on a $100 investment or 3% quarterly (12%
annual cash yield).
3. The interest rate for borrowing and lending until the settlement date. The
borrowing and lending rate is referred to as the financing cost. In our example,
the financing cost is 2% for the 3 months.
We will assign the following:
r = financing cost
y = cash yield
P = cash market price ($)
F = futures price ($)
The theoretical futures price ;
F =P+P(r-y)
Our previous example to determine the theoretical futures price ;
r= 00.2
y= 00.3
P= $ 100
Then , the theoretical futures prises is:
F= $ 100 + $ 100 ( 0.02 0.03 )
F= $ 100 - $ 1
F= $ 99

Hedging Fundamentals
Hedging with futures typically involves taking a position in a futures
market that is opposite the position already held in a cash market.
A Short (or selling) Hedge: Occurs when a firm holds a long cash position
and then sells futures contracts for protection against downward price
exposure in the cash market.
A Long (or buying) Hedge: Occurs when a firm holds a short cash position
and then buys futures contracts for protection against upward price exposure
in the cash market. Also known as an anticipatory hedge.
A Cross Hedge: Occurs when the asset underlying the futures contract
differs from the product in the cash position

Firms can hold long and short hedges simultaneously (but for different price
risks).
General Principles of Hedging With Futures
The major function of futures markets is to transfer price risk from hedgers to
speculators. That is, risk is transferred from those willing to pay to avoid risk to those
wanting to assume the risk in the hope of gain. Hedging in this case is the
employment of a futures transaction as a temporary substitute for a transaction to
be made in the cash market. The hedge position locks in a value for the cash
position. As long as cash and futures prices move together, any loss realized on one
position (whether cash or futures) will be offset by a profit on the other position.
When the profit and loss are equal, the hedge is called a perfect hedge.
Risk Associated with Hedging
The term r - y, which reflects the difference between the cost of financing and the
asset's cash yield, is called the net financing cost. The net financing cost is more
commonly called the cost of carry or, simply, carry.
The amount of the loss or profit on a hedge will be determined by the relationship
between the cash price and the futures price when a hedge is placed and when it is
lifted. The difference between the cash price and the futures price is called the
basis.
That is, basis = cash price - futures price
if a futures contract is priced according to its theoretical value, the difference
between the cash price and the futures price should be equal to the cost of carry.
The risk that the hedger takes is that the basis will change, called basis risk.
Cross-hedging
Cross-hedging is common in asset/liability and portfolio management because
no futures contracts are available on specific common stock shares and bonds.
Cross-hedging introduces another riskthe risk that the price movement of
the underlying instrument of the futures contract may not accurately track the
price movement of the portfolio or financial instrument to be hedged. It is
called cross-hedging risk.
Therefore, the effectiveness of a cross-hedge will be determined by:
1. The relationship between the cash price of the underlying instrument and
its futures price when a hedge is placed and when it is lifted.
2. The relationship between the market (cash) value of the portfolio and the
cash price of the instrument underlying the futures contract when the
hedge is placed and when it is lifted.
Long Hedge versus Short Hedge
A short (or sell) hedge is used to protect against a decline in the future cash
price of a financial instrument or portfolio.

To execute a short hedge, the hedger sells a futures contract (agrees to make
delivery).
A long (or buy) hedge is undertaken to protect against an increase in the
price of a financial instrument or portfolio to be purchased in the cash market
at some future time.

Valuation of Financial Futures

Futures contract price related to the price of the underlying asset
Inverse relationship between debt contract prices and interest rates applies to
futures prices
Futures contract price reflects the expected price of the underlying asset or
index as of the settlement date
Anything that affects the price of the underlying asset affects the futures price
Speculating with Interest Rate Futures
Long position; purchase futures contracts
Strategy to use if speculator anticipates interest rates will decrease and bond
prices will increase
Buy a futures contract and if rates drop the contracts price rises above what it
cost to purchase and exchange adds gain with daily settlement to investors
account
If interest rates rise instead of fall, futures contract price drops and investors
account is reduced by daily loss
Speculating with Interest Rate Futures
Short position; sell futures contracts
Strategy to use if speculator anticipates interest rates will rise and contract
prices drop
Sell (short) a futures contract and close the position by buying a contract to
offset short
If rates rise, the price to buy the contract and close the position is less than
the price received for the initial sale of the contract
Speculator loses money if rates drop
Closing out the Futures Position
Most buyers and sellers of futures contracts do not actually make or take
delivery of the underlying asset
Can close position any time before contract expiration date
Offset or close out their positions in the futures market by the settlement date
Trade the same contract and maturity month to open and close the position
Obligations net out when traders close

Examples
o Open with the sale of a June maturity T-bill, close with the purchase of a
June maturity T-bill
o Open with the purchase of a June maturity T-bill and close with the sale
of the same kind of contract and maturity--June T-bill
Gain or loss on a position depends on purchase price compared to the selling
price
Daily settlement with exchange

Risk of Trading Futures Contracts

Dealing with basis risk

Identify futures contract with price changes closely related to the

underlying asset
o Cross hedging involves using a futures contract with an underlying
asset different from the asset to hedge, for example, hedge commercial
paper rate exposure with T-bills futures
Liquidity risk
o Price distortions if a contract is not widely traded
o Need a counterparty to close position
o

Credit risk
o Counterparty defaults
o Not a risk on exchange-traded contracts where exchange serves as the
counter-party
Prepayment risk
o Assets (e.g. loans) prepaid sooner than their designated maturity
o Leaves hedger without an offsetting spot position in a speculative
position
Operational risk
o Inadequate management or controls
o For example, hedging firms employees do not understand how futures
contract values respond to market conditions
o Lack of controls may result in speculative positions

Regulation in the Futures Markets

More awareness about systemic risk given recent events in the markets
Problems at one firm can affect other firms ability to honor contractual
agreements
Regulators want participants to have sufficient collateral to back their
positions
Accounting regulators goal is disclosure so risks are clear
Institutional Use of Futures Markets
Most activity is for hedging, not speculating
Many kinds of institutions uses futures
o Commercial banks
o Savings institutions
o Securities firms
o Mutual funds
o Pension funds
o Insurance companies