INVESTMENTS:INVESTMENTS:Analysis and ManagementAnalysis and Management

Second Canadian EditionSecond Canadian Edition

W. Sean Cleary

Charles P. Jones

Chapter 20Chapter 20

FuturesFutures

• Describe the structure of futures markets.

• Outline how futures work and what types of investors participate in futures markets.

• Explain how financial futures are used.

Learning ObjectivesLearning Objectives

• Spot or cash market Price refers to item available for immediate

delivery• Forward market

Price refers to item available for delayed delivery• Futures market

Sets features (contract size, delivery date, and conditions) for delivery

Understanding Futures MarketsUnderstanding Futures Markets

• Futures market characteristics Centralized marketplace allows investors to trade

with each other Performance is guaranteed by a clearinghouse

• Valuable economic functions Hedgers shift price risk to speculators Price discovery conveys information

Understanding Futures MarketsUnderstanding Futures Markets

• Commodities – agricultural, metals, and energy related

• Financials – foreign currencies as well as debt and equity instruments

• Foreign futures markets Increased number shows the move toward

globalization

Understanding Futures MarketsUnderstanding Futures Markets

• An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today Trading means that a commitment has been

made between buyer and seller Position offset by making an opposite contract

in the same commodity

Futures ContractFutures Contract

• Where futures contracts are traded• Voluntary, nonprofit associations, typically

unincorporated• Organized marketplaces where established

rules govern conduct Financed by membership dues and fees for

services rendered

• Members trade for self or for others

Futures ExchangesFutures Exchanges

• A corporation separate from, but associated with, each exchange

• Exchange members must be members or pay a member for these services Buyers and sellers settle with clearing

corporation, not with each other

• Helps facilitate an orderly market• Keeps track of obligations

The Clearing CorporationThe Clearing Corporation

• Through open-outcry, seller and buyer agree to take or make delivery on a future date at a price agreed on today Short position (seller) commits a trader to

deliver an item at contract maturity Long position (buyer) commits a trader to

purchase an item at contract maturity

• Like options, futures trading is a zero-sum game

The Mechanics of TradingThe Mechanics of Trading

• Contracts can be settled in two ways: Delivery (less than 1% of transactions) Offset: liquidation of a prior position by an

offsetting transaction

• Each exchange establishes price fluctuation limits on contracts

• No restrictions on short selling• No assigned specialists

The Mechanics of TradingThe Mechanics of Trading

• Good faith deposit made by both buyer and seller to ensure completion of the contract Not an amount borrowed from broker

• Each clearing house sets its own requirements Brokerage houses can require higher margin

• Initial margin usually less than 10% of contract value

Futures MarginFutures Margin

• Margin calls occur when price goes against investor Must deposit more cash or close account Position marked-to-market daily Profit can be withdrawn

• Each contract has maintenance or variation margin level below which the investor’s net equity cannot drop

Futures MarginFutures Margin

• Hedgers At risk with a spot market asset and exposed

to unexpected price changes Buy or sell futures to offset the risk Used as a form of insurance Willing to forgo some profit in order to reduce

risk• Hedged return has smaller chance of low return

but also smaller chance of high return

Using Futures ContractsUsing Futures Contracts

• Short (sell) hedge Cash market inventory exposed to a fall in value Sell futures now to profit if the value of the

inventory falls• Long (buy) hedge

Anticipated purchase exposed to a rise in cost Buy futures now to profit if costs increase

HedgingHedging

• Basis: difference between cash price and futures price of hedged item Must be zero at contract maturity

• Basis risk: the risk of an unexpected change in basis Hedging reduces risk if basis risk less than

variability in price of hedged asset

• Risk cannot be entirely eliminated

Hedging RisksHedging Risks

• Speculators Buy or sell futures contracts in an attempt to

earn a return• No prior spot market position

Absorb excess demand or supply generated by hedgers

Assuming the risk of price fluctuations that hedgers wish to avoid

Speculation encouraged by leverage, ease of transacting, low costs

SpeculatingSpeculating

• Contracts on equity indexes, fixed income securities, and currencies

• Opportunity to fine-tune risk-return characteristics of portfolio

• At maturity, stock index futures settle in cash Difficult to manage delivery of all stocks in a

particular index

Financial FuturesFinancial Futures

• Interest rate futures If increase (decrease) in rates is expected, sell

(buy) interest rate futures• Increase (decrease) in interest rates will decrease

(increase) spot and futures prices Difficult to short bonds in spot market

Interest Rate FuturesInterest Rate Futures

• Selling futures contracts against diversified stock portfolio allows the transfer of systematic risk Diversification eliminates nonsystematic risk Hedging against overall market decline Offset value of stock portfolio because futures

prices are highly correlated with changes in value of stock portfolios

Hedging with Stock Index FuturesHedging with Stock Index Futures

• Index arbitrage: a version of program trading Exploitation of price difference between stock

index futures and the cash price of the underlying index

Arbitrageurs build hedged portfolio that earns low risk profits equaling the difference between the value of cash and futures positions

Program TradingProgram Trading

• Futures effective for speculating on movements in stock market because: Low transaction costs involved in establishing

futures position Stock index futures prices mirror the market

• Traders expecting the market to rise (fall) will buy (sell) index futures

Speculating with Stock- Index Speculating with Stock- Index FuturesFutures

• Futures contract spreads Both long and short positions at the same time in

different contracts Intramarket (calendar or time) spread

• Same contract, different maturities Intermarket (quality) spread

• Same maturities, different contracts

• Interested in relative price as opposed to absolute price changes

Speculating with Stock-Index Speculating with Stock-Index FuturesFutures

Appendix 20-A Future OptionsAppendix 20-A Future Options

• Put and call options are offered on both interest rate futures and stock-index futures

• Several options on futures contracts: On foreign exchange: pound, mark, Swiss franc, yen,

etc. On interest rate futures: US Treasury bills, notes and

bonds On stock-index futures: The S&P 500 Index, NYSE

Composite Index, and the Nikkei 225 Stock Average On commodities: Agricultural, oil, livestock, metals and

lumber

Appendix 20-A Futures OptionsAppendix 20-A Futures Options

• Key elements of a future option are the exercises price and the premium

• Future options contracts can serve some the same purposes as the futures contracts themselves

• A rise in interest rates is bearish, so the portfolio manager would either buy a put or sell a call

• Appeal of future options is the limited liability assumed by the purchaser

Appendix 20-BAppendix 20-BOther Derivative SecuritiesOther Derivative Securities

• Swap A cash settled forward agreement with a series of

predetermined payments• Interest rate swaps represent agreements to

exchange cash flows on an agreed upon formula; the notional or principal amount is not exchanged, either at initiation or maturity of the contract

• Foreign exchange swaps or currency swaps: the notional amount is exchanged at the beginning and end of the contract; not necessarily have to be fixed for floating

• Swaptions give the holder the right to enter into a swap agreement.

Appendix 20-BAppendix 20-BOther Derivative SecuritiesOther Derivative Securities

• Embedded Options Include features such as convertible, callable,

retractable, and extendible features associated with some debt or preferred share issues

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