FINC4101 Investment Analysis Instructor: Dr. Leng Ling Topic: Introduction to Futures

Learning objectives Define futures contracts. Understand the various features of futures: price, maturity, margins, etc. Describe how futures trading is organized. List the positions of futures contracts. Marking to market. Trading strategies. The payoffs and profits are computed at expiration.

Forwards An agreement between two parties to exchange cash for a commodity or financial asset at some specific time in the future at a predetermined price. Terms are unique to each individual forward contract. That is, each contract is customized. There is a risk that one side might default on its’ obligation.

Forwards Example: Cotton is now traded at $1000 per ton in spot market. You would like to purchase one ton and receive it 111 days from today. You would like to enter into a “forward contract”. I am willing to accommodate you in this desire. Now we must agree on the forward price that you must pay me after 111 days and how the commodity will be delivered.

Futures A standardized “forward contract” traded on an organized and regulated futures exchange. Futures contracts are guaranteed by the exchange’s clearinghouse that eliminates the risk of the other party’s default. Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date. A deposit called “margin” is required to both buyers and sellers.

Standardized Contract Terms Example: a CBOT wheat Futures contract Quantity: 5,000 bushels Commodity type: No.2 Soft Red, etc. Expiration: July, September, December, March, and May Delivery place: in a warehouse approved by CBOT Minimum price change (tick size): 0.25 cents per bushel or $12.50 per contract.

Clearinghouse Guarantees that all traders in the futures markets will honor their obligations. Act in a position of buyer to every seller and seller to every buyer. So no default risk as a counter-party to every trader.

Forwards vs. Futures Futures contracts trade on an organized exchange. Futures positions can be closed or transferred easily. Futures contracts have standardized terms (quantity, expiration, etc.) Futures contracts are guaranteed by the clearinghouse associated with the exchange. Futures are subject to daily settlement (marked to the market). Margin is required to both the buyer and seller.

Futures and Options

Margin and Daily Settlement Initial margin (5-15% of the underlying asset’s value) Maintenance margin Marking to market: realize any loss or profit in cash every day. Example: Long an oat future in CBT, 5000 bushels, initial margin is $1,400, maintenance margin is $1100. Margin Call

Another Example of Margin (example 17.1) Suppose the maintenance margin is 5% while the initial margin was 10% of the value of the corn futures that has 5,000 bushes. At day 0, the price of the future is 353.25 cents/bushel. Q1: how much initial margin does the buyer or seller need to deposit at day 0? Q2: at what price does the buyer receive a margin call? Q3: at what price does the seller receive a margin call? Q1: contract value 353.25x5,000=$17,662.50 initial margin 17662.50x10%= $1766.25 maintenance margin 17662.5x5%=$883.125 Q2: Loss allowed $ 883.125 loss for each drop in cent 5000x0.01=$50 883.125/50=17.6625 cent 353.25-17.6625=335.5875 cent/bushel or (x-3.5325)5000=-883.125 x=3.355875 dollar Q3: (x-3.5325)5000=883.125 x=3.709125 dollar

Margin and Leverage Initial margin is10%; current oil futures price is $39.48; contract size of 1,000 barrels. Initial margin: 0.1*39.48*1000=$3,948 If price increases by $2 (5.0659%=2/39.48), then gain =2*1000=$2000/contract (2000/3948=50.659%), which is 10 times the percentage change in price. leverage: 10--1

Another Example of Marking to Market Example 17.2 (page 552)

Closing a Position Delivery Offset – reverse trade Cash settlement: make payment at expiration date to settle any gains or losses, instead of making physical delivery.

Zero Sum Game At maturity date T: Profit to long = PT - original futures price Profit to short = Original futures price - PT

Main Futures Exchanges CME group CME CBOT COMEX NYMEX

Types of Futures Commodities: wheat, oat, cotton Foreign currencies: euro, British pound, Canadian dollar, Japanese yen. Interest-earning assets: Treasury notes and bonds, Eurodollar deposits Indexes: S&P500, Dow Joes, NASDAQ 100 Individual stocks, e.g., IBM.

Participants in Futures Markets Hedgers: hedging, risk management Speculators: make money by taking risk Brokers: receive commission fee Regulators: futures exchanges and clearinghouses, the National Futures Association, the Commodity Futures Trading Commission

Treasury Bill Futures Trading cycles: Mar/Jun/Sep/Dec the underlying: the $1 million T-bill with 90-day maturity. No actual delivery, cash settlement. quotation: CME IMM index = 100.00 – Discount Yield

Example of Treasury Bill Futures Quotations

T-bill Futures Example Jim Sanders purchased a T-bill futures with the price of 94.00 (a 6% discount) and that the price as of the March settlement date is 94.90 (a 5.1 % discount). What is the profit from the trade? 94.9%x1,000,000-94.00%x1,000,000=9,000

T-bill Futures Example 2 Jim Sanders purchased a T-bill futures with the price of 94.00 (a 6% discount) and that the price as of the March settlement date is 92.50 (a 7.5 % discount). What is the profit from the trade? 92.5%x1,000,000-94.00%x1,000,000=-15,000

T-Bond Futures (maturity is over 10 years) Treasury Bond Futures (quotation on page 546) Trading cycles: Mar/Jun/Sep/Dec Quotations in points and 32nd of par. e.g., 97-26 (97.8215) Underlying: $100,000 worth (face value) of deliverable T-Bonds Cash settlement or delivery Tick size is 1/32nd of 0.01 (1/32x0.01x$100,000=$31.25)

T-bond Futures Example A speculator purchased a futures on Treasury bond at a price of 90-00. One month later, the speculator sells the same contract at 92-10. Given the par value of the contract is $100,000, what is the profit? (92+10/32)x0.01x100,000 - (90+00/32)0.01x100,000 =2,312.50

Interest Rate and Futures Price General rule for interest rate futures price: If interest rates are expected to go up, the price of interest rate futures will go down, and vice verse.

Stock Index Futures Contracts Main stock index futures See next slide Features: Cash settlement Trading cycle (March, June, September, December) Different contract dollar multipliers Quotations for stock index futures. (Figure 17.1)

Stock Index Futures Contracts

Stock Index Futures Example 1 The spot S&P500 index is 1300. Boulder Insurance company plans to purchase a variety of stocks for its stock portfolio in December. It anticipates a large jump in stock market before December. The futures price on the S&P500 index with a December settlement date is 1500. The value of an S&P500 futures contract is $250 times the index. If the S&P500 index rises to 1600 on the settlement date, what is the profit if the company buy one future now? 1600x250-1500x250=$25,000

Stock Index Futures Example 2 Assume that a portfolio manger has a well diversified stock portfolio valued at $2,000,000. Also assume that S&P500 index futures contracts are available for a settlement date one month from now at a level of 1600, which is equal to today’s index value. How does the manager do to hedge the stock portfolio? Sell futures. $2,000,000/(1600x$250)=5 contracts If market goes down by 5%, then … If market goes up by 5%, then …

Single Stock Futures a. A contract to buy or sell a single stock (usually 100 shares) b. Settlement dates are quarterly c. Offer potentially high returns (with high risk) d. Closing out involves taking opposite position anytime before settlement date

Speculating with Oil Futures Example 17.3 (page 554)

Hedging with Oil Futures Example 17.5 (page 554)

Spot-Futures Parity Page 557

Arbitrage (Example 17.8) Page 558.

Homework Assignment 12 Chapter 17: 1,3,4,5,11,13,19