1. Financial Futures Markets13

2. Chapter Objectives Explain how financial futures contracts are valued
Explain the use of futures to speculate or hedge based on anticipated interest rate changes
Explain the use of stock index futures to speculate or hedge based on anticipated stock price movements
Describe how financial institutions participate in futures markets

3. Background on Financial Futures
Futures are a derivative security
Derivatives
Securities whose value is derived from the value of some underlying asset or financial instrument
Derivative security prices related to factors affecting prices in the spot market
For example, bond futures prices are related to what is happening in markets where bonds are bought and sold for immediate delivery

4. Background on Financial Futures
Standardized agreement to deliver or take delivery of a financial instrument at a specified price and date
Price is determined by traders for standardized contracts
The underlying financial instrument
Settlement date
Form of delivery for underlying asset
Trading on organized exchanges provides liquidity and guaranteed settlement

5. Background on Financial Futures
Exchange members trade contracts in trading pits
Organized exchanges include Chicago Board of Trade and Chicago Mercantile Exchange
Only members or those leasing privileges can transact business on the floor of the exchange
Commission brokers
Floor traders
Regulated by the Commodities Futures Trading Commission or CFTC

6. Background on Financial Futures
Establish account and initial margin
Maintenance margin and margin call
Order to trading floor
Open outcry trading
Clearinghouse function
Daily market-to-market of contracts
Steps Involved in Trading Futures

7. Background on 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
Purpose of Trading Financial Futures

8. Interpreting Financial Futures Tables
Futures contract prices reported in the financial press
Columns of information for each maturity month that is trading
Open, high, low and the settlement or closing price
Change in the closing price from the previous day
Open interest or how many contracts are outstanding for a particular maturity

9. Valuation of Financial Futures
Futures contract price related to the price of the underlying asset
Inverse relationship between debt contract prices and interest rates applies to futures prices
Futures contract price reflects the expected price of the underlying asset or index as of the settlement date
Anything that affects the price of the underlying asset affects the futures price
Impact of opportunity costs or benefits

10. Bond Futures Contract Price Changes
Prices of Treasury bond futures move with spot market
Correlation of price movements in spot and futures important to hedgers and speculators
Market participants in futures monitor the same kinds of economic indicators and interest rate information as
Investors who own bonds
Investors who expect to buy bonds
Borrowers who might plan on issuing debt

11. Exhibit 13.3 Framework for Futures Price Changes Over Time
International
Economic
Conditions
U.S.
Fiscal
Policy
U.S.
Monetary
Policy
U.S.
Economic
Conditions
Long-Term
Risk-Free
Interest
Rate
(Treasury
Bond Rate)
Short-Term
Bill Rate)
Required
Return
on Treasury
Bond
Bill
Price of
Treasury
Bond
Bill
Expected
Movements in
Treasury
Bond Prices
Not Embedded
in Existing
Prices
Price of
Treasury
Bond
Futures
Bill
Expected
Movements in
Treasury
Bill Prices
Not Embedded
in Existing
Prices a

12. Speculating with Interest Rate Futures
Long position; purchase futures contracts
Strategy to use if speculator anticipates interest rates will decrease and bond prices will increase
Buy a futures contract and if rates drop the contract’s price rises above what it cost to purchase and exchange adds gain with daily settlement to investor’s account
If interest rates rise instead of fall, futures contract price drops and investor’s account is reduced by daily loss

13. Exhibit 13.4 Potential Payoff From Speculative Futures Position
Profit or
Profit or
Loss from
Loss from
Purchasing
Selling
a Futures
a Futures
Contract
Contract S
Market V
alue
of the
Futures
Contract
as of the
Settlement
Date S
Market V
alue
of the
Futures
Contract
as of the
Settlement
Date

14. Speculating with Interest Rate Futures
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

15. Closing out the Futures Position
Most buyers and sellers of futures contracts do not actually make or take delivery of the underlying asset
Can close position any time before contract expiration date
Offset or close out their positions in the futures market by the settlement date
Trade the same contract and maturity month to open and close the position
Obligations net out when traders close

16. Closing out the Futures Position
Examples
Open with the sale of a June maturity T-bill, close with the purchase of a June maturity T-bill
Open with the purchase of a June maturity T-bill and close with the sale of the same kind of contract and maturity--June T-bill
Gain or loss on a position depends on purchase price compared to the selling price
Daily settlement with exchange

17. Hedging with Interest Rate Futures
Using interest rate futures to create a short hedge
Hedger adversely affected by an interest rate increase
Bank using primarily short-term funds to finance longer-term assets
Hurt by rising rates; must refinance funding before investment re-priced

18. Hedging with Interest Rate Futures
The short hedge
Sell futures contracts with characteristics similar to the securities being hedged
If rates increase, hedger closes out the position at a profit in the futures market to offset spot market position opportunity loss (reduced interest margin)
If rates decrease, hedger’s spot market gains (wider interest margin) offset by losses on the futures position

19. Hedging with Interest Rate Futures
Using interest rate futures to create a long hedge
Examples of adverse effects of a decrease in interest rates
Plan to purchase debt securities in a few months and if rates decline, the purchase price of bonds increases—long futures position locks in price of bonds
Bank finances loans whose rates adjust every six months with CDs that have a two-year term—long futures position locks in loan rates to maintain spread
Hedger uses futures position to offset spot losses and gains—locks in a price or spread

20. Hedging with Interest Rate Futures
Hedging net exposure
Futures hedges have transaction costs
Net exposure is the difference between asset and liability positions

21. Bond Index Futures Bond index futures
Muni-bond index futures (MBI)
Bond buyers index
Uses of bond index futures to hedge
Insurance company using future cash inflows to buy municipal bond in near future; interest rate decreases will raise bond prices
Investment banking firm underwriting bonds; hurt if interest rates rise, decreasing bond prices
Position to gain in futures if loss occurs in spot

22. Stock Index Futures Types of index futures contracts
Several different index contracts traded on the Chicago Board of Trade and Chicago Mercantile Exchange
Securities underlying the contract not deliverable-- cash settlement
Contract’s price is the index times the dollar value given in the contract’s specifications
For example, Chicago Merc S&P contract is the index value times $250

23. Stock Index Futures
Value of futures contract highly correlated with the value of the underlying index
Differences or advantages and disadvantages to owning the actual index versus futures
Under some circumstances, arbitrage profits are possible
Indicators monitored by the market include anything affecting the underlying index

24. Stock Index Futures Speculating with stock index futures
Capitalize on expectations without having sufficient cash to buy the actual stocks in index
Expect an increase in stock prices, buy index futures; gain/losses leveraged with small investment
Hedging with stock index futures
Hedge market risk of an existing portfolio
Pension fund manager with reasonable return for year sells index futures contracts to lock in return

25. Stock Index Futures Hedging issues
Hedge is more effective if investor’s portfolio is diversified like the the underlying index for the futures contract
Portfolio managers do not necessarily hedge the entire portfolio
Dynamic asset allocation with stock index futures
Portfolio manager uses stock index futures to vary risk/return position of portfolio without restructuring existing stock portfolios
An efficient risk management technique

26. Stock Index Futures Prices of stock index futures versus stocks
Differ to some degree
Index futures prices may be higher or lower than the underlying index
Stock index futures can more rapidly change as expectations change—investors watch as indicator of market direction
Differentials reduce hedging effectiveness
Test of suitability of stock index futures

27. Stock Index Futures Arbitrage with stock index futures
Institutional investors capitalize on differences between price of index futures and stock prices
Simultaneous buy/sell program trading when there is a profitable difference between index futures and stocks represented in the underlying index
Serves to “tie” the index value to that of the corresponding stock portfolio used by other investors to hedge or speculate

28. Stock Index Futures Circuit breakers on stock index futures
Suspends trading on specific stocks or stock indexes after a specified market decline
Gives investors a chance to evaluate information or meet margin calls before trading resumes
Impacts program trading which has been linked to market volatility

29. Risks of Trading Futures Contracts
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

30. Risk of Trading Futures Contracts
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

31. Risk of Trading Futures Contracts
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

32. Risk of Trading Futures Contracts
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

33. Regulation in the Futures Markets
More awareness about systemic risk given recent events in the markets
Problems at one firm can affect other firm’s ability to honor contractual agreements
Regulators want participants to have sufficient collateral to back their positions
Accounting regulators goal is disclosure so risks are clear

34. Institutional Use of Futures Markets
Most activity is for hedging, not speculating
Many kinds of institutions uses futures
Commercial banks
Savings institutions
Securities firms
Mutual funds
Pension funds
Insurance companies

35. Globalization of Futures Markets
Non-U.S. participation in U.S. futures contracts
Foreign stock index futures on foreign stock indexes and markets
Financial futures also available for selected foreign debt instruments
Currency futures contracts for few large country currencies