INTRODUCTION TO FINANCIAL FUTURES MARKETS CHAPTER 10 Emre Dülgeroğlu Yasin Çöte Rahmi Özdemir Kaan Soğancı

Our purpose in this chapter is to provide an introduction to financial futures contracts, how they are priced, and how they can be used for hedging.

What a futures contract is? 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. 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.

who do you use futures contracts markets? 1. Hedgers 2. Speculators 3. Brokers

MECHANICS OF FUTURES TRADING A futures contract is a firm legal agreement between a buyer and an established exchange or its clearinghouse in which the buyer agrees to take delivery of something at a specified price at the end of a designated period of time. The price at which the parties agree to transact in the future is called the futures price. The designated date at which the parties must transact is called the settlement date.

LIQUIDATING A POSITION Most financial futures contracts have settlement dates in the months of March, June, September, or December. The contract with the closest settlement date is called the nearby futures contract. The contract farthest away in time from the settlement is called the most distant futures contract. A party to a futures contract has two choices on liquidation of the position. First, the position can be liquidated prior to the settlement date. The alternative is to wait until the settlement date.

Clearinghouse A clearinghouse is agency associated with an exchange, which settles trades and regulates delivery.

THE ROLE OF THE CLEARINGHOUSE Associated with every futures exchange is a clearinghouse, which performs several functions, one of these functions is guaranteeing that the two parties to the transaction will perform. Besides its guarantee function, the clearinghouse makes it simple for parties to a futures contract to unwind their positions prior to the settlement date.

MARGIN REQUIREMENTS When a position is first taken in a futures contract, the investor must deposit a minimum dollar amount per contract as specified by the exchange. Three kinds of margins specified by the exchange: 1) initial margin (may be an interest-bearing security such as a Treasury bill, cash, or line of credit) 2) maintenance margin (specified by the exchange) 3) variation margin (additional margin to bring it back to the initial margin if the equity falls below the maintenance margin, must be in cash).

MARKET STRUCTURE On the exchange floor, each futures contract is traded at a designated location in a polygonal or circular platform called a pit. The price of a futures contract is determined by open outcry of bids and offers in an auction market. Floor traders include two types: locals and floor brokers.

Daily Price Limits The exchange has the right to impose a limit on the daily price movement of a futures contract from the previous session's closing price.

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.

Futures contracts Forward contracts Standardized contract (delivery date, quality, quantity) yes no Where to be traded (primary market) organized exchanges over-the-counter instrument Credit risk (default risk) Clearinghouse Settlement marked-to-market (daily) end of the contract Margin requirement Transaction cost low high Regulations

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 = $107 Payment received from investing in Asset XYZ for 3 months = $3 Total proceeds = $110 2. From the Loan Repayment of principal of loan = $ 100 Interest on loan (2% for 3 months) = 2 Total outlay = $102 Profit = $ 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 Then , the theoretical futures prises is: F= $ 100 + $ 100 ( 0.02 – 0.03 ) F= $ 100 - $ 1 F= $ 99

Difference Between Lending and Borrowing Rate The borrowing rate is greater than the lending rate. Letting; rB = borrowing rate rL = lending rate F = P + p(rB-y) F = P + p(rL-y)

For example, assume that the borrowing rate is 8% per year, or 2% for 3 months, while the lending rate is 6% per year, or 1.5% for 3 months. The upper boundary and lower boundary for the theoretical futures price is: F(upper boundary) = $100 + $100(0.02 - 0.03) = $ 99 F(lower boudary) = $100 + $100(0.015 - 0.03) = $ 98.50

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 risk—the 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.

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