2. Futures Markets I. The Development of Futures Markets –1. Chicago Board of Trade (1848) – grain –2. Chicago Mercantile Exchange (1898) – merge of Chicago Produce Exchange & Chicago Butter & Egg Board –3. Financial Futures A. Foreign Currency Futures (1972) B. GNMA Futures (1975) C. T-Bill Futures (1976) D. T-Bond Futures (1977) E. Eurodollar Futures (1981) S&P500 Index Futures (1982) Dow-Jones Index Futures (1997)

3. II. Futures Contracts –1. Forward Contract vs. Futures Contract –2. Basics of Futures Contract Types of Futures –Grains & Oilseeds –Livestock & Meat –Food and Fiber –Metals & Energy –Financials & others Quotations (Bonds) (Contract Specifications) III. Mechanics of Trading –1. Trading Pits vs. GLOBEX –2. The Clearing House

4. –3. Marking to Market Initial Margin & Maintenance Margin (Performance Bond) Daily Settlement –Example Cash Deliver vs. Actual Delivery –Actual delivery: less than 1% –Cash delivery: stock index futures Regulations –CFTC: Commodity Futures Trading Commissions –Price Limit (e.g., silver @ $1/per day) IV. Futures Market Strategies –1. Hedging Short Hedge –Long cash, short futures

5. Long Hedge -short cash, long futures -Examples - If you own an asset - If you plan to sell an asset - If you are short an asset - If you are committed to buying an asset in the future - If you have issued a floating rate liability - If you plan to issue a liability

6. Bond Portfolio _____ Hedge A long-term bond portfolio manager forecasts that interest rate will increase over the next few months. The manager holds a portfolio of $1 million face value, 11- 7/8s, 2023 corporate bond. DateSpot MarketsFutures Markets 3/25 Market yield= 11.74% Market value = $1,010,000 Futures price = 70-16/32 Yield = 14.92% 3/25 No actionShort 15 contracts 1,010,000/70500= 14.32 4/28 Yield increases to 12.44%Price of T-bond futures decreases to 66-23/32 Market value of cash bond = 95-22/32 Long 15 June T-bond futures 4/28 Loss = 1,010,000 – 956,875 = 53,125 Gain = (70,500-66,718) (15) = 56,730

7. Stock Portfolio Short Hedge – On 3/1, a portfolio manager was concerned about the market over the next six months. StockPrice (3/1)SharesMV (3/1)Price (9/2)MV (9/2) GLW14.6815,000220,20019.50292,500 WFMI126.351,000126,350128.25128,250 XMSR31.754,000127,00034.50138,000 INTC22.485,000112,40025.60128,000 DELL36.255,000181,25034.50172,500 WMT47.755,000238,75044.55222,750 AMT18.6515,000279,75023.65354,750  1,285,7001,436,750 On 3/1, the SP500 index futures was @1,190, the manager shorted 5 contracts {[1,285,700/ (1,190 x 250)]=4.3} On 9/2, SP500 index futures is @ 1,218, the manager longs 5 contracts. Loss in the futures: (1,218-1,190) x250 x 5 = 35,000

8. 2. Hedge Ratio –Naïve hedge ratio –Minimum variance hedge ratio Run a linear regression line  S =  +   F, where  is the minimum variance hedge ratio # of futures contract: N =  (S/F) 3. Which futures commodity? –Cross Hedge – choose the one that has high correlation between futures price and underlying asset price 4. Which Expiration? –Choose a future with expiration month close to but after the hedge terminates –Deferred contract may have liquidity problem

9. V. Futures Pricing –Spot-Futures Parity (Cost of Carry Model) –1. F 0 = S 0 (1+r) T Example: F 0 = 360(1.05) 1 = 378 –2. Arbitrage occurs when the equilibrium relation is violated (e.g., F 0 = 380) Example T 0 T 1. T 0 : borrow $360 $360 buy gold -$360 short futures@380 0 T 1 : deliver gold $380 repay loan (P&I) -$378 ---------------------------------------------------------------------- Cash flows 0 +2

10. V. Other Futures & Forwards –1. Options on Futures –2. Hedging with Foreign Currency Forwards Scenario: On June 1, a multinational firm with a British subsidiary decides it will need to transfer ￡ 10 million from an account in London to an account with a NY bank. Transfer will be made on September 6. The firm is concerned that pound will weaken. DateSpot MarketForward Markets 6/1 The spot exchange rate is $1.362 per pound; forward rate is $1.357 Forward value of fund=10,000,000($1.357)=$13, 570,000 Short pounds forward for delivery on 9/6 @ $1.357 9/6 The spot rate is $1.2375Deliver pounds and receive 10,000,000($1.357)=$13,570,000 Analysis: The ￡ end up worth $13,570,000 – 12,375,000 = $1,195,000 less but are delivered on the forward contract for $13,570,000, thus eliminating the risk.