FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER TWENTY CHAPTER TWENTYFutures

Learning Objectives 1. Explain how futures contracts differ from options. 2. Discuss the difference between futures contracts and forward contracts. 3. Define the terms backwardation and forwardation. 4. Explain arbitrage and demonstrate how it works in commodity and financial futures. 5. Describe how different types of futures (foreign currency, interest rate, stock index, etc.) contribute to risk management.

Introduction Physical commodities and financial instruments are traded in cash markets Physical commodities and financial instruments are traded in cash markets Two types of cash markets: Two types of cash markets: spot markets – feature immediate delivery spot markets – feature immediate delivery forward markets – have deferred delivery forward markets – have deferred delivery A way to mitigate risk is through: A way to mitigate risk is through: Forward contracts – a negotiated agreement between a buyer and a seller to lock in a price at which a future transaction will occur Forward contracts – a negotiated agreement between a buyer and a seller to lock in a price at which a future transaction will occur

Introduction Who uses forward contracts? Who uses forward contracts? oil production and refinery companies oil production and refinery companies mining companies mining companies An alternative way of locking in future prices is through: An alternative way of locking in future prices is through: Futures contracts – agreements to trade a specified asset at a specified price and time in the future Futures contracts – agreements to trade a specified asset at a specified price and time in the future Characteristics of futures contracts include: Characteristics of futures contracts include: Ý contracts are standardized Ý they trade on futures markets Ý they are contracts with a futures market clearing house

Basic Concepts Conceptually, forward or futures contracts can be written on anything, including oil, grains, metals, weather, currencies, and interest rates Conceptually, forward or futures contracts can be written on anything, including oil, grains, metals, weather, currencies, and interest rates Futures contracts can be divided into two broad categories: Futures contracts can be divided into two broad categories: 1. commodities – agricultural, metal, and energy-related products 2. financials – foreign currencies, debt and equity instruments

Basic Concepts Commodity futures contract – when the underlying asset is a real commodity Commodity futures contract – when the underlying asset is a real commodity Financial futures contracts – when the underlying asset is a financial obligation such as currency, bond, or stock portfolios Financial futures contracts – when the underlying asset is a financial obligation such as currency, bond, or stock portfolios Futures price – is the price set out in a futures contract Futures price – is the price set out in a futures contract Settle price – the price at which the market’s books were balanced at the end of the day’s trading Settle price – the price at which the market’s books were balanced at the end of the day’s trading

Basic Concepts Organized exchanges are crucial to the usefulness of futures contracts as risk- management tools Organized exchanges are crucial to the usefulness of futures contracts as risk- management tools Futures trade on: Futures trade on: Ý WCE, ME (Canada) Ý CME, NYCE, NYME, NYFE (US) Futures contracts have maturities of less than seven years Futures contracts have maturities of less than seven years Futures contracts are standardized Futures contracts are standardized

Options and Futures Options give the owner the right to buy or sell the underlying asset Options give the owner the right to buy or sell the underlying asset Futures and forward contracts carry the obligation to trade the underlying asset Futures and forward contracts carry the obligation to trade the underlying asset Both options and futures are zero sum investment Both options and futures are zero sum investment

Organization of Futures Markets Investors must establish a commodity or margin account in order to trade futures contracts Investors must establish a commodity or margin account in order to trade futures contracts Margin requirements are between 5 and 10 percent of the value of the position Margin requirements are between 5 and 10 percent of the value of the position Futures markets are subject to daily limits on price fluctuations Futures markets are subject to daily limits on price fluctuations Investors in futures may also be subject to position limits Investors in futures may also be subject to position limits

Marketing to Market Marking to market – the futures markets elaborate system of daily adjustments of contract prices and margin accounts Marking to market – the futures markets elaborate system of daily adjustments of contract prices and margin accounts Neither party deals directly with each other Neither party deals directly with each other On futures exchanges, almost 90 percent of all positions are closed out before they mature On futures exchanges, almost 90 percent of all positions are closed out before they mature

Hedges and Speculators Hedgers – traders who open futures positions to manage risk that arises from other businesses Hedgers – traders who open futures positions to manage risk that arises from other businesses hedgers: hedgers: Ý are in the market to buy insurance Speculators – investors who open futures positions expecting to close them again at more advantageous prices Speculators – investors who open futures positions expecting to close them again at more advantageous prices speculators: speculators: Ý provide liquidity to the market and increase efficiency Ý are in the market to make money

Commodity Futures Prices The Expectations Hypothesis The Expectations Hypothesis states that future prices of a commodity should be what traders expect the spot price to be in the future states that future prices of a commodity should be what traders expect the spot price to be in the future The Net Hedging Hypothesis The Net Hedging Hypothesis Normal backwardation – when a futures market has a shortage of hedgers in long positions which means the futures contract price will fall below the spot price expected in the future (F  E(S)) Normal backwardation – when a futures market has a shortage of hedgers in long positions which means the futures contract price will fall below the spot price expected in the future (F  E(S)) Normal forwardation – a futures market with a shortage of hedgers on the short side of the contract which causes the future price to exceed the expected spot price (F > E(S)) Normal forwardation – a futures market with a shortage of hedgers on the short side of the contract which causes the future price to exceed the expected spot price (F > E(S))

Commodity Futures Prices Commodity Futures Arbitrage Commodity Futures Arbitrage l when futures contracts approach maturity the futures price equals the spot price, otherwise an arbitrage situation occurs l For assets that are not maturing, arbitrageurs set limits on the difference between the futures prices and the current spot prices known as “boundaries”

Commodity Futures Prices The boundaries formula is: F  S(1 + r) t + ct The boundaries formula is: F  S(1 + r) t + ct where: where: F = future price F = future price S = spot price S = spot price r = annual risk-free interest rate r = annual risk-free interest rate t = time until maturity of the futures contract measured in years t = time until maturity of the futures contract measured in years c = annual storage, insurance, transportation for carrying an inventory of underlying assets c = annual storage, insurance, transportation for carrying an inventory of underlying assets When the futures prices exceeds the upper limit there is a arbitrage situation When the futures prices exceeds the upper limit there is a arbitrage situation

Financial Futures Prices Foreign currency futures: Foreign currency futures: allow one to lock in an exchange rate at a specified point in the future allow one to lock in an exchange rate at a specified point in the future are available in all major currencies are available in all major currencies are valuable risk-management tools for firms that engage in international business are valuable risk-management tools for firms that engage in international business Foreign currency exposure – the term used when a business has a net contractual obligation in a foreign currency Foreign currency exposure – the term used when a business has a net contractual obligation in a foreign currency

Financial Futures Prices Interest rate forward and futures contracts allows one to lock in a price at which a debt instrument is to be bought or sold in the future Interest rate forward and futures contracts allows one to lock in a price at which a debt instrument is to be bought or sold in the future Interest rate futures should be considered when: Interest rate futures should be considered when: 1. Borrowers want to protect against future interest rate increases 2. Investors want to protect against future interest rate decreases 3. Financial institutions are exposed to interest rate risk 4. Speculators want to bet on interest rates moving in a particular direction

Financial Futures Prices Stock index futures: Stock index futures: l allows one to lock in a future price at which one can buy the portfolio of stocks that make up a stock market index l are for specified amounts of underlying assets l are settled in cash

Financial Futures Prices Program trading – when institutions use direct computer links to stock exchanges to assemble large portfolios of stocks that are based on theoretical equivalence of positions in index futures and their underlying stocks Program trading – when institutions use direct computer links to stock exchanges to assemble large portfolios of stocks that are based on theoretical equivalence of positions in index futures and their underlying stocks

Summary 1. Futures contracts and forward contracts are devices for locking in prices for future transactions. They commit the investor to buying or selling in the future at that price. There is no choice on whether or not to exercise. Futures and forward contracts are less flexible than options. Their compensating benefit is that futures entail no up-front cost.

Summary 2. Futures contracts are standardized agreements with futures market clearing houses to buy or sell assets at specified times and prices. Commodity futures contracts are for important agriculture products, metals, oil, and other commodities. Financial futures contracts that allow one to buy or sell foreign currencies, debt instruments, and stock portfolios have become important risk- management devices.

Summary 3. If a commodity futures price is lower than the spot price traders expect to see at the time the futures contract matures, the market for that futures contract is said to display backwardation. If the futures price is higher than the expected spot price, the market is said to display forwardation.

Summary 4. Commodity futures are set by the interaction of the supply and demand for price hedging, but are limited by an arbitrage constraint. Futures contracts are important tools for risk management. Commodity futures contracts can be used to lock in prices for the firm’s inputs and products and hedge against price changes.

Summary 5. Foreign currency futures can be used to lock in exchange rates and limit foreign currency risk. Interest rate futures lock in the prices and yields of debt instruments, allowing firms to hedge against the risk of interest rate fluctuations. Stock index futures contracts lock in the prices of stock portfolios based on widely used stock indices.