1 CHAPTER 13 Financial Future Markets

2 Derivatives A derivative transaction involves no actual transfer of ownership of the underlying assets at the time the contract is initiated. A derivative represents an agreement to transfer ownership of underlying assets at a specific place, price, and time specified in the contract. Its value (or price) depends on the value of the underlying assets. The underlying assets: stocks, bonds, interest rates, foreign exchanges, index, commodities, some derivatives, etc.

3 Main Types of Derivatives Forward Futures Options Swaps

4 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. 1. Terms are unique to each individual forward contract. That is, each contract is customized. 2. There is a risk that one side might default on its’ obligation.

5 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 is delivered.

6 Futures A standardized “forward contract” traded on an organized and regulated futures exchange. 1. Futures contracts are guaranteed by the exchange’s clearinghouse that eliminates the risk of contra-party default. 2. Each contract is standardized on the quantity, quality, delivery place, delivery date, contract expiration date. 3. A deposit called “margin” is required to both buyers and sellers.

7 Forwards vs. Futures 1. Futures contracts trade on an organized exchange. 2. Futures positions can be closed or transferred easily. 3. Futures contracts have standardized terms (quantity, expiration, etc.) 4. Futures contracts are guaranteed by the clearinghouse associated with the exchange. 5. Futures are subject to daily settlement (marked to the market). 6. Margin is required to both the buyer and seller.

8 Options A contract that is associated with a right to buy or sell a commodity or financial assets until a specific date with a predetermined price and amount, etc. There are Call options and Put options. 1. The buyer of a Call option has the right, not the obligation, to buy an asset. 2. The buyer of a Put option has the right, not the obligation, to sell an asset.

9 Swaps An agreement between two parties to exchange sequences of cash flows over a period in the future. Example: exchange of a fixed rate of interest for a floating rate of interest.

10 Application of Derivatives Hedging and risk management Speculation

Futures markets Originated for trade of agricultural commodities Financial futures has a history of about 30 years. Four main categories (physical commodities, foreign exchange instruments, interest- earning assets, stock indices) Long vs. Short positions

Main Futures Exchanges Chicago Board of Trade (CBT): futures on T- bonds and agricultural products. Chicago Mercantile Exchange (CME): futures on money market securities, stock indexes, and currencies.

Standardized Contract Terms Example: a CBT 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 CBT 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.

Margin and Daily Settlement Initial margin (5-18% 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

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.

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

Different Interest Rate Futures 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 = – Discount Yield

Exhibit 13.1 Example of Treasury Bill Futures Quotations

T-bill Futures Example 1(p.340) Jim Sanders purchased a T-bill futures with the price of (a 6% discount) and that the price as of the March settlement date is (a 5.1 % discount). What is the profit from the trade? 94.9%x1,000, %x1,000,000=9,000 21

T-bill Futures Example 2 Jim Sanders purchased a T-bill futures with the price of (a 6% discount) and that the price as of the March settlement date is (a 7.5 % discount). What is the profit from the trade? 92.5%x1,000, %x1,000,000=-15,000 22

T-Bond Futures ( maturity is over 10 years) Treasury Bond Futures (quotation on page 345) Trading cycles: Mar/Jun/Sep/Dec Quotations in points and 32 nd of par. e.g., ( ) Underlying: $100,000 worth (face value) of deliverable T-Bonds Cash settlement or delivery Tick size is 1/32 nd of 0.01 (1/32x0.01x$100,000=$31.25)

T-bond Futures Example 1(p.341) A speculator purchased a futures on Treasury bond at a price of One month later, the speculator sells the same contract at 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.

T-bond Futures Example 2 You are managing an existing long-term bond portfolio. If you expect higher long-term interest rates in the future, how can you hedge your bond portfolio against the interest rate risk? Charlotte Insurance (page 342).

Stock Index Futures Contracts Main stock index futures (Exhibit 13.7, p347) See next slide Features: Cash settlement Trading cycle (March, June, September, December) Different contract dollar multipliers Quotations for stock index futures. (page 348)

Exhibit 13.7 Stock Index Futures Contracts

Stock Index Futures Example 1 The spot S&P500 index is 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 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? 1600x x250=$25,000 29

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 … 30

31 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

32 Institutional Use of Futures Markets 1. Commercial banks 2. Savings institutions 3. Securities firms 4. Mutual funds 5. Pension funds 6. Insurance companies

Exhibit Institutional Use of Futures Markets

Homework Assignment 8 Problems: