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Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.
Chapter Outline
Background on financial futures Interpreting financial futures tables Valuation of financial futures Explaining price movements of bond futures contracts Speculating with interest rate futures Closing out the futures position
A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date
The buyer of a futures buys the instrument while the seller delivers the instrument The exchanges clear, settle, and guarantee all transactions that occur on the exchange
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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Traded either to speculate on prices of securities or to hedge existing exposure to security price movements Speculators take positions to profit from expected changes in the price of futures contracts over time
Day traders attempt to capitalize on price movements during a single day Position traders maintain their futures positions for longer periods of time
Hedgers take positions to reduce their exposure to future movements in interest rates or stock prices
Electronic trading
The
Chicago Mercantile Exchange established GLOBEX that compliments its floor trading
Allows for around the clock and weekend trading
The
Chicago Board Options Exchange implemented a fully electronic futures exchange in 2004
Commission brokers, who execute orders for their customers and are often employed by brokerage firms Floor traders (locals), who trade futures contracts for their own account
Many
Initial margin is typically between 5 and 18 percent of a futures full value Customers may receive a margin call if the value moves in an unfavorable direction
A market order is executed at the prevailing price of the futures contract A limit order is executed only if the price is within the limit specified
Brokerage firms communicate customers order to telephone stations located near the trading floor Floor brokers accommodate orders When two traders on the floor reach an agreement through open outcry, the information is transmitted to the customers Floor brokers receive transaction fees in the form of a bidask spread The futures exchange acts as a clearinghouse
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The Wall Street Journal provides a comprehensive summary of trading activity on various financial futures contracts Example of Treasury bill futures quotations:
Discount
Open
Sept 2005 93.80
High
94.05
Low
Settle
Change
+.28
Settle
5.95
Change
.28
Open
2,519
93.80 94.05
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In points ($1,000) and thirty-seconds In points ($1,000) and thirtyof a point seconds of a point One thirty-second (1/32) of a point, or $31.25 per contract Three points ($3,000) per contract above or below the previous days settlement price March, June, September, December One thirty-second (1/32) of a point, or $31.25 per contract Three points ($3,000) per contract above or below the previous days settlement price March, June, September, December
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Settlement months
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:
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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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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Involves trading T-bill futures The position taken depends on interest rate expectations
If interest rates are expected to decline, purchase T-bill futures If interest rates are expected to increase, sell T-bill futures
The maximum possible loss when purchasing futures is the amount to be paid for the securities
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0 MV of Futures at Settlement
0 MV of Futures at Settlement
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Impact of leverage
The
return is magnified substantially when considering the relatively small margin maintained by many investors
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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
If the futures price has risen over the holding period, speculators who purchased interest rate futures will realize a positive gain
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The difference between a financial institutions volume of rate-sensitive assets and ratesensitive liabilities represents its exposure to interest rate risk
In
the long run, the institution could restructure its assets or liabilities In the short run, the institution could use financial futures to hedge its exposure to interest rate movements
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an institution has more rate-sensitive liabilities than assets, it will be adversely affected by rising interest rates
The institution could sell futures on securities with similar characteristics than its assets If interest rates rise, the loss on the rate-sensitive assets will be offset by the gain on the short futures position
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Interest rate futures can hedge against both adverse and favorable events The probability distribution of returns is narrower with hedging than without hedging Institutions that frequently use interest rate futures may be able to reduce the variability of their earnings over time
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Cross-hedging is the use of a futures contract on one financial instrument to hedge a position in a different financial instrument
The effectiveness depends on the degree of correlation between the market values of the two financial instruments e.g., a short position in Treasury bond futures to hedge interest rate risk of a portfolio of corporate bonds Even with a high correlation, the value of the futures contract may change by a higher or lower percentage than the portfolios market value
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an institution has more rate-sensitive assets than liabilities, it will be adversely affected by declining interest rates
The institution could purchase T-bill futures to lock in the price at a specified future date If interest rates decline, any reduction in the banks earnings will be offset by the gain on the short futures position
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exposure reflects the difference between asset and liability positions e.g., a bank has both long-term fixed-rate liabilities and long-term assets
If interest rates rise, the value of assets will decline, but the bank benefits from the fixed rate of long-term liabilities
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A bond index futures contract allows for the buying an 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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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 Some speculators prefer to trade stock index futures rather than actual stocks because of the smaller transaction costs
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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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Participants in the futures market monitor indicators that may signal changes in the stock indexes
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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The
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Usefulness can be assessed by measuring the sensitivity of the portfolios performance to market movements Determine whether a hypothetical derivative position would have offset adverse market effects on the portfolios performance Portfolio managers may be partially exposed in the event the stock price rises The higher the proportion of the portfolio that is hedged, the more insulated the managers performance is from market conditions
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In dynamic asset allocation, investors switch between risky and low-risk investment position in response to changing expectations
e.g., buy stock index futures if favorable market conditions are expected
Prices of index futures and the index can differ to some degree Recent studies have found a high degree of correlation between the stock index futures and the index itself
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trading in conjunction with the trading of stock index futures is known as index arbitrage
Securities firms act as arbitrageurs and attempt to capitalize on discrepancies between prices of index futures and stocks Index arbitrage involves the buying or selling of stock index futures with a simultaneous opposite position in the stocks that the index comprises
Instigated when futures prices differ significantly from the stock represented by the index
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breakers are trading restrictions imposed on specific stocks or stock indexes The CME imposes circuit bakers on the S&P 500 futures contract Circuit breakers allow investors to determine whether circulating rumors are true and to work out credit arrangements if they have received a margin call
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A single stock futures contract is an agreement to buy or sell a specified number of shares of a specified stock on a specified future date Nominal size of a contract is 100 shares Investors can buy or sell futures through their broker Settlement dates are on the third Friday of March, June, September, and December for the next 5 quarters, as well as the nearest two months Investors can buy single stock futures on margin Single stock futures are regulated by the Commodity Futures Trading Commission (CFTC) and the SEC Investors can close out their position at any time by taking the opposite position OneChicago is a joint venture between the CBOE and the CBOT which serves as another market for trading single stock futures
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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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Systemic risk is the risk that a particular even could spread adverse effects among several firms or among financial markets Regulators have attempted to reduce systemic risk by:
Ensuring that participants in derivative markets have adequate collateral to back their positions Ensuring that participants fully disclose their exposure to risk resulting from derivative positions
The Fed monitors commercial banks capital Accounting regulators revised accounting standards in 1994 to require more disclosure about derivative positions
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Mutual funds
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 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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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
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