INVESTMENTS: Analysis and Management Second Canadian Edition INVESTMENTS: Analysis and Management Second Canadian Edition W. Sean Cleary Charles P. Jones

Chapter 20 Futures

Describe the structure of futures markets. Outline how futures work and what types of investors participate in futures markets. Explain how financial futures are used. Learning Objectives

Spot or cash market  Price refers to item available for immediate delivery Forward market  Price refers to item available for delayed delivery Futures market  Sets features (contract size, delivery date, and conditions) for delivery Understanding Futures Markets

Futures market characteristics  Centralized marketplace allows investors to trade with each other  Performance is guaranteed by a clearinghouse Valuable economic functions  Hedgers shift price risk to speculators  Price discovery conveys information Understanding Futures Markets

Commodities – agricultural, metals, and energy related Financials – foreign currencies as well as debt and equity instruments Foreign futures markets  Increased number shows the move toward globalization Understanding Futures Markets

An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today  Trading means that a commitment has been made between buyer and seller  Position offset by making an opposite contract in the same commodity Futures Contract

Where futures contracts are traded Voluntary, nonprofit associations, typically unincorporated Organized marketplaces where established rules govern conduct  Financed by membership dues and fees for services rendered Members trade for self or for others Futures Exchanges

A corporation separate from, but associated with, each exchange Exchange members must be members or pay a member for these services  Buyers and sellers settle with clearing corporation, not with each other Helps facilitate an orderly market Keeps track of obligations The Clearing Corporation

Through open-outcry, seller and buyer agree to take or make delivery on a future date at a price agreed on today  Short position (seller) commits a trader to deliver an item at contract maturity  Long position (buyer) commits a trader to purchase an item at contract maturity Like options, futures trading is a zero-sum game The Mechanics of Trading

Contracts can be settled in two ways:  Delivery (less than 1% of transactions)  Offset: liquidation of a prior position by an offsetting transaction Each exchange establishes price fluctuation limits on contracts No restrictions on short selling No assigned specialists The Mechanics of Trading

Good faith deposit made by both buyer and seller to ensure completion of the contract  Not an amount borrowed from broker Each clearing house sets its own requirements  Brokerage houses can require higher margin Initial margin usually less than 10% of contract value Futures Margin

Margin calls occur when price goes against investor  Must deposit more cash or close account  Position marked-to-market daily  Profit can be withdrawn Each contract has maintenance or variation margin level below which the investor’s net equity cannot drop Futures Margin

Hedgers  At risk with a spot market asset and exposed to unexpected price changes  Buy or sell futures to offset the risk  Used as a form of insurance  Willing to forgo some profit in order to reduce risk Hedged return has smaller chance of low return but also smaller chance of high return Using Futures Contracts

Short (sell) hedge  Cash market inventory exposed to a fall in value  Sell futures now to profit if the value of the inventory falls Long (buy) hedge  Anticipated purchase exposed to a rise in cost  Buy futures now to profit if costs increase Hedging

Basis: difference between cash price and futures price of hedged item  Must be zero at contract maturity Basis risk: the risk of an unexpected change in basis  Hedging reduces risk if basis risk less than variability in price of hedged asset Risk cannot be entirely eliminated Hedging Risks

Speculators  Buy or sell futures contracts in an attempt to earn a return No prior spot market position  Absorb excess demand or supply generated by hedgers  Assuming the risk of price fluctuations that hedgers wish to avoid  Speculation encouraged by leverage, ease of transacting, low costs Speculating

Contracts on equity indexes, fixed income securities, and currencies Opportunity to fine-tune risk-return characteristics of portfolio At maturity, stock index futures settle in cash  Difficult to manage delivery of all stocks in a particular index Financial Futures

Interest rate futures  If increase (decrease) in rates is expected, sell (buy) interest rate futures Increase (decrease) in interest rates will decrease (increase) spot and futures prices  Difficult to short bonds in spot market Interest Rate Futures

Selling futures contracts against diversified stock portfolio allows the transfer of systematic risk  Diversification eliminates nonsystematic risk  Hedging against overall market decline  Offset value of stock portfolio because futures prices are highly correlated with changes in value of stock portfolios Hedging with Stock Index Futures

Index arbitrage: a version of program trading  Exploitation of price difference between stock index futures and the cash price of the underlying index  Arbitrageurs build hedged portfolio that earns low risk profits equaling the difference between the value of cash and futures positions Program Trading

Futures effective for speculating on movements in stock market because:  Low transaction costs involved in establishing futures position  Stock index futures prices mirror the market Traders expecting the market to rise (fall) will buy (sell) index futures Speculating with Stock- Index Futures

Futures contract spreads  Both long and short positions at the same time in different contracts  Intramarket (calendar or time) spread Same contract, different maturities  Intermarket (quality) spread Same maturities, different contracts Interested in relative price as opposed to absolute price changes Speculating with Stock-Index Futures

Appendix 20-A Future Options Put and call options are offered on both interest rate futures and stock-index futures Several options on futures contracts:  On foreign exchange: pound, mark, Swiss franc, yen, etc.  On interest rate futures: US Treasury bills, notes and bonds  On stock-index futures: The S&P 500 Index, NYSE Composite Index, and the Nikkei 225 Stock Average  On commodities: Agricultural, oil, livestock, metals and lumber

Appendix 20-A Futures Options Key elements of a future option are the exercises price and the premium Future options contracts can serve some the same purposes as the futures contracts themselves A rise in interest rates is bearish, so the portfolio manager would either buy a put or sell a call Appeal of future options is the limited liability assumed by the purchaser

Appendix 20-B Other Derivative Securities Swap  A cash settled forward agreement with a series of predetermined payments Interest rate swaps represent agreements to exchange cash flows on an agreed upon formula; the notional or principal amount is not exchanged, either at initiation or maturity of the contract Foreign exchange swaps or currency swaps: the notional amount is exchanged at the beginning and end of the contract; not necessarily have to be fixed for floating Swaptions give the holder the right to enter into a swap agreement.

Appendix 20-B Other Derivative Securities Embedded Options  Include features such as convertible, callable, retractable, and extendible features associated with some debt or preferred share issues

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