FINANCIAL FUTURES MARKETS

Financial Future Market-skw 10/15/2018

 Introduction
2

 Forward, futures, and options are collectively

known as derivatives
 What is a derivative?
 Securities whose value is derived from the value of some
underlying asset or financial instrument
 Why are derivatives useful?
 They help eliminate the price risk inherent in
transactions that call for future delivery of money,
security, or a commodity.

Financial Future Market-skw 10/15/2018

 Background on Financial Futures
3

Purpose of Trading Financial Futures

 To Speculate
 Take a position with the goal of profiting from expected
changes in the contract’s price
 No position in underlying asset

 To Hedge
 Minimize or manage risks

 Have position in spot market with the goal to offset risk

Financial Future Market-skw 10/15/2018

 Definition of a forward contract
4

A forward contract is an over-the-counter

contract between two parties that defines a
transaction in the future by specifying the date,
amount of goods, and unit price.

On the transaction date, the seller is expected to

deliver the goods to the buyer and receive
payment. This type of contract creates counter-
party risk

Financial Future Market-skw 10/15/2018

 Definition of futures contract
5

Futures contracts were created to eliminate the

counter-party risk of a forward contract by
making the counter-party in every futures
contract the futures exchange.

A futures contract is a standardized contract with

an exchange that specifies the date, amount of
goods, and unit price for a transaction in the
future.

Financial Future Market-skw 10/15/2018

 Definition of futures contract (continued)
6

Unlike a forward contract, the seller in the futures

contract seldom delivers on the contract.

Futures contracts are not designed for buying the

underlying asset, but instead for price estimation
and risk management in the transactions involving
the underlying asset.

Financial Future Market-skw 10/15/2018

 Definition of futures contract (continued)
7

There are two types of positions taking in futures

contracts:
1. a long position, which is an agreement to buy the
underlying asset, and
2. a short position, which is an agreement to sell the
underlying asset.

Financial Future Market-skw 10/15/2018

 Forward contracts (continued)
8

A popular forward contract is one that fixes the

interest rate on a loan that will occur at some time in
the future. This type of forward contract is a forward
rate agreement (FRA).

Financial Future Market-skw 10/15/2018

 Characteristics of FRAs
9

A FRA is an over-the-counter product offered by

banks.
The buyer of the FRA is the notional borrower and is
protected against rising interest rates.
The seller of the FRA is the notional lender and
therefore sets the rate for lending. The seller is
protected against falling rates.

Financial Future Market-skw 10/15/2018

 Characteristics of FRAs (continued)
10

The notional loan is for a specified amount in a

specified currency that will be drawn on a
particular future date and will last for a specified
duration.

So, a FRA is described as A x B, where

A = deferral period and
B = deferral period + coverage period.

Thus, a FRA that covers 1 year (12 months) but does

not start for 9 months is a 9 x 12.
Financial Future Market-skw 10/15/2018
 Characteristics of FRAs (continued)
11

No lending takes place at the time that the FRA is

arranged. Instead, the FRA provides protection
against interest rate changes.

If interest rates rise, the seller makes a payment to

the buyer.

If interest rates decline, the buyer makes a payment

to the seller.

Financial Future Market-skw 10/15/2018

 Characteristics of FRAs (continued)
12

The protection from the FRA comes in the form

of a cash payment called the settlement sum.

S FRA 
 Rr  Rc * A * (days basis )
1  Rr * (days basis ) 
where
Rr = the reference rate,
Rc = the contract interest rate,
A = the notional contract amount,
days = number of days in the contract period, and
basis = the day count convention (360 for $ and 365 for £).

Financial Future Market-skw 10/15/2018

 Characteristics of FRAs (continued)

Example for the settlement payment (SFRA) of a 3x6

FRA with the following contract inputs: Rr = 5.15%, Rc =
5.25%, A = $75,000,000 days = 90 days, and basis = 360 days.

S FRA 
.0515  .0525* 75,000,000 * (90 / 360)
 18,512
1  .0515 * (90 / 360
So, the buyer owes a settlement payment to the seller of $18,512
and the payment is made at the beginning of the coverage
period.
10/15/2018 Financial Future Market-skw
13
 Characteristics of FRAs (continued)
14

Example of a 3x6 FRA

FRA contract Actual rate Difference in

negotiated known here actual & contract
here value found here

Deferral period Coverage period

0 3 months 6 months

Difference discounted
at actual rate to here

Financial Future Market-skw 10/15/2018

 Futures
15

A futures contract is an obligation to buy or sell a

specific quantity and quality of the underlying
asset at a certain price on a specified future
date.
Each futures contract has a delivery month where
the contract comes due.
Futures contract are seldom held to maturity
(only 3% are held to maturity). Instead, they
are closed out by offsetting transactions.

Financial Future Market-skw 10/15/2018

 Futures (continued)
16

Live Cattle LC
Class IV Milk DK
Feeder Cattle FC
Butter DB
E-mini Feeder Cattle FM
Lumber LB
Lean Hogs LH
Oriented Strand Boards (OSB) BD
Frozen Pork Bellies PB
e-Hogs HM
Milk DA

Contract Month Symbols

January F July N
February G August Q
March H September U
April J October V
May K November X
June M December Z

Financial Future Market-skw 10/15/2018

 Interest Rate Futures (continued)
17

Suppose you need to make a specific investment in a

project in July. It is currently January, but you know
that money for the investment will arrive in April.
Your concern is what interest rate you can earn on the
money from April to July.
Now, we know we can invest the money in April in T-
bills that mature in July and receive a certain amount
at maturity. However, we still don’t know the rate of
interest we will earn because we are in January.

Financial Future Market-skw 10/15/2018

 Interest Rate Futures (continued)
18

However, we can lock in an interest rate in January by

buying (going long) an April T-bill futures contract (a
future that matures in April) because T-bill futures
contract cover a three-month period.

January February March April May June July

Attempting Funds Invest

to lock arrive
interest rate
Financial Future Market-skw 10/15/2018
 Interest Rate Futures (continued)
19

Interest rate futures prices are quoted as

(100 – rate).
Futures have two margin requirements.
1. Initial margin = deposit needed to a the
inception of the transaction, and
2. Variation margin = daily gain or loss on your
futures position that occurs because all futures
contracts on ‘marked to market’ daily, which
creates margin risk.
3. Minimum margin = point where a margin call
occurs

Financial Future Market-skw 10/15/2018

 Interest Rate Futures (continued)
20

Example of contract specification for an interest rate

futures contract.
Three-Month Interest Rate Futures
Trading Unit $1,000,000
Delivery/Expiry Mar., Jun., Sep. & Dec
Quotation 100 – rate of interest
Min price movement 0.01
Tick size $25

Financial Future Market-skw 10/15/2018

 Interest Rate Futures (continued)
21

The tick size is very important because it is the

minimum margin variation in the contract.
The tick size for this contract is $25, which is a 1 basis
point change in interest on $1,000,000 for three
months
$25 = (0.0001/4*$1,000,000)

Financial Future Market-skw 10/15/2018

 Interest Rate Futures (continued)
22

Example of using an interest rate futures contract

to hedging interest rate risk exposure

Assume that your business plan’s to spend a

$10,000,000 on a new project at the beginning of
September. The money for the project comes
from the sale of an old plant that no longer fits the
needs of the business. The sale of the old plant
occurs at the beginning of June. Thus, you are
exposed to interest rate changes from June to
September (3 months).

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
23

April May June July Aug. Sept. Oct.

Old Plant Sale Investment

Exposure to
interest rate
changes

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
24
Now that we know the timing (both starting point
and length) when need to determine the
number of contract.

Using our example contract in slide 20, we see

that the contract is for $1 million, so to hedge
the interest rate on our investment we need 10
contract.
Note, we got lucky. Usually you won’t get an exact
number of contracts for a hedge.

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
25

Now, we must decide whether we need to be a

buyer or sell in the futures contract.
Hedgers are buyers in a futures contract when
they need the underlying asset so they want a
contract to buy (a long position).
Hedgers are sellers in a futures contract when
they have the underlying asset, but want to sell
the asset in the future (a short position).
We need the underlying asset (T-bills) so we are
the buyer in the futures contract.

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
26

So, we want to buy 10 T-bill futures contracts and the

current price is 93.51 so the interest rate we are
getting is 6.49%.

Recall, that the tick size is $25 for each contract, so

with 10 contract a 1 basis point change in interest
rates cause a margin variation of $250 in our margin
account.

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
27

Finally, we need to decide which expiration month we

need on our contract.
The money becomes available in June for a three-
month investment in T-bills that will mature in
September at the time of the new project. So, we
need T-bill futures contracts that expires in June.

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
28

Now, assume the price of our contracts at

expiration (in June) is 94.45 (an interest rate of
5.55%).
The settlement price of 94.45 is 94 ticks higher
than the price at purchase of 93.51, which
means an increase in our margin account of
$23,500 = 94 ticks * $250/tick. This means
that we made a profit in the futures market.

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
29

Now, we take the money from the sale of the old plant
($10 mil.) and invest in T-bills at a yield of 5.55%
We earn $138,750 = 10,000,000*5.55%*3/12.

Combining the T-bill earnings with the futures

earnings we make $162,250 = 138,750 + 23,500

Financial Future Market-skw 10/15/2018

 Interest Rate Futures Example (continued)
30

Our profits of $162,250 provide a total return of

6.49% (($162,250/$10,000,000)*12/3), which
is the interest rate we locked in on our futures
contract when we bought the contract.
Thus, market interest rates changed, but our
position in the futures contract allowed us to
earn the interest rate at the time we entered into
the futures contract.

Financial Future Market-skw 10/15/2018

 Typical Transactions in Futures Market
31

 Shorthedge
Bank has corporate bonds (similar to T-bonds)
If “i” is expected to increase=>price of corporate bonds
decrease=> sell T-bond futures
If “i” increase as expected=>lose from corporate bonds but
offset with T-bond futures.
If “i” decrease=>loss

Financial Future Market-skw 10/15/2018

 Typical Transactions in Futures Market
32

 Speculation
 Long position; purchase futures contracts
 A strategy to use if speculator anticipates interest
rates will decrease and bond prices will increase
 Expect “i” go “down”=>T-bill price go “up”=>buy futures at
$90=>settlement day
1.if T-bill price > $90 => profit
2.if T-bill price < $90 => loss

Financial Future Market-skw 10/15/2018

 Speculating with Interest Rate Futures
33

 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

Financial Future Market-skw 10/15/2018

 Stock Index Futures
34

Another popular futures contract is a contract for a

stock index future, such as the S&P 500 composite
index futures contract.

The purpose of this futures contract is to manage the

exposure of a stock portfolio to changes in portfolio
value from general market movements.

Financial Future Market-skw 10/15/2018

 Using stock index futures
35

Let’s assume that we own a portfolio of stocks and

that we believe that the market will decline in
value dramatically in the near future.
Since, we don’t want to lose value in our portfolio
when the market declines we can either sell the
portfolio now or hedge the portfolio. We choose
to hedge because we like the long-term potential
of our portfolio.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
36

So, how do we hedge our portfolio?

Step 1: Find a stock index futures contract that is

highly correlated with our portfolio. In this case, we
will use the E-mini S&P 500 futures because our
portfolio is heavily weighted toward large cap stocks.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
37

Step 2: Determine whether we need to be long or

short in the futures market. Since we own the
portfolio and want to protect our value we take
a short position to lock in a sales value.

Recall, a short position gives us the right to sell

the underlying asset at the price locked in with
our futures contract.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
38

Step 3: Determine the number of contracts needed to

hedge our portfolio, which currently has a value of
$62,300. The value of one E-mini S&P 500 futures
contract is calculated at $50 x the futures index
number, which is currently 1210, so the value of one
E-mini futures contract is $60,500. Thus, we need
one contract.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
39

Now, assume that we were correct and market did

decline dramatically and our portfolio lost 10% of its
value, falling to $56,070. This results in a loss of
$6,230 = $62,300 - $56,070.

In addition, assume the E-mini S&P 500 futures

contract fell to 1091, which represents a value of
$54,550 = 1091 x $50. This is a decline in the futures
value of $5,950 = $60,500 - $54,550.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
40

Recall, that we took a short position in the futures

contract which is the position to sell. Thus, the
reversing position is to buy a contract. Since we sold
the futures contract at $60,500 and we buy it back at
$54,550, the change in value for the futures contract
of $5,950 is profit.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
41

Thus, we hedge the loss on our portfolio of $6,230

with a gain on the futures contract of $5,950, which
results in a net loss of only $280.

Note, the hedge was not prefect, so we did not

eliminate risk. However, we did reduce the loss
substantially.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
42

There are two reasons that this hedge was not

prefect (did not eliminate risk).
1. The value of the futures contract did not
exactly match the value of the portfolio. This
a frequently a limitation with hedging.
2. The futures contract and the portfolio are
highly correlated, but not a exact match, so
there is tracking error.

Financial Future Market-skw 10/15/2018

 Using stock index futures (continued)
43

What happens if we are wrong about the market and it

goes up in the near future instead of down?
The answer is our hedge will work in the opposite
direction to eliminate profits on our portfolio with
losses on the future. If this occurs, we will need to
consider removing our hedge.

Financial Future Market-skw 10/15/2018

 Stock Index Futures
44

 Arbitrage by Stock-index Futures

 Buy stock index – get dividends
 Buy stock index futures=>use less asset
(margin)=>rent loan 2%=>buy stock (3%
dividend)
 Arbitrage possibility=>buy fund 2% interest
and sell futures until futures down spot up 1%

Financial Future Market-skw 10/15/2018

 Risks of Trading Futures Contracts
45

 Market risk
 Speculators win or lose based on changing market value of
futures contracts
 Hedgers, with a position in the underlying asset, are not
significantly impacted by contract price volatility
 Basis risk
 Futures contract prices do not vary in exactly the same way as
the underlying asset’s price
 Price correlation of contract and underlying asset impacts the
ability to hedge market risk

Financial Future Market-skw 10/15/2018

 Risk of Trading Futures Contracts
46

 Dealing with basis risk

 Identify futures contract with price changes closely related to
the underlying asset
 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
 Price distortions if a contract is not widely traded

 Need a counterparty to close position

Financial Future Market-skw 10/15/2018

 Risk of Trading Futures Contracts
47

 Credit risk
 Counterparty defaults

 Not a risk on exchange-traded contracts where exchange

serves as the counter-party
 Prepayment risk
 Assets (e.g. loans) prepaid sooner than their designated
maturity
 Leaves hedger without an offsetting spot position in a
speculative position

Financial Future Market-skw 10/15/2018

 Risk of Trading Futures Contracts
48

 Operational risk
 Inadequate management or controls

 For example, hedging firm’s employees do not understand how

futures contract values respond to market conditions
 Lack of controls may result in speculative positions

Financial Future Market-skw 10/15/2018