1. FINANCIAL FUTURES MARKETS
CHAPTER 13
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Dr David P Echevarria

2. Derivative Securities
What are Derivative Securities?
High leverage securities that can be used to;
Speculate or
Hedge
How do we speculate?
Suppose we believe that the weather will reduce this year’s wheat harvest. A poor harvest will result in higher prices. We can open a long futures October contract for wheat. If as the year progresses, the weather cooperates – the price will go up > profit!
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Dr David P Echevarria

3. Derivative Securities
How do we hedge?
A hedge is a form of insurance.
Suppose we are a jeweler and we use a lot of gold to make custom pieces. If the price of gold rises, so will our costs. To hedge against a rise in prices we open a long gold hedge. If prices rise – we will profit from the long hedge and offset the increased cost of buying new supplies of gold.
If we are a seller of gold – our fear is that prices will drop. We will open a short futures hedge. If prices drop, we will profit on the short position.
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Dr David P Echevarria

4. VALUATION OF FINANCIAL FUTURES
Market Value of Futures Contracts
Value is dependent on the value of the underlying security
Derivative Securities may also be called contingent claims
Primary economic function = HEDGING MARKET RISK
Interest Rate Futures used to hedge against adverse changes in interest rates
The hedger is protecting a long or short position in the market
The speculator expect to profit if rates in the expected direction (up or down)
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Dr David P Echevarria

5. VALUATION OF FINANCIAL FUTURES
Forward Contracts; (Not publicly traded)
Agreement to buy/sell at a future time
The LONG position: party agreeing to buy the asset
The SHORT position: party agreeing to deliver (sell) asset
Delivery Price: price specified in the forward contract
Settlement on a Forward contract occurs at maturity
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Dr David P Echevarria

6. VALUATION OF FINANCIAL FUTURES
Futures Contracts: (publicly traded)
Contracts are standardized
Delivery date: by month and the exchange on which contract is traded sets the delivery date
For commodities, may be anytime during the expiration month
Daily Settlement or Marking-to-Market on price changes
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Dr David P Echevarria

7. VALUATION OF FINANCIAL FUTURES
Arbitrage and the Law of One Price:
Two identical goods cannot sell for two different prices
When prices are not in sync, arbitrage opportunity
Risk Management:
Hedging against adverse future price movements (market risk)
Price discovery; expectations of future price levels
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Dr David P Echevarria

8. FUNDAMENTALS OF FUTURES MARKETS
Forward Markets
Deferred delivery (expected price at time T)
Utilizing the storability factor
Hedging future price movements resulting from changes in Supply and Demand
Forward vs. Futures Contracts
Price discovery
Spot (Cash) Market:
Immediate delivery (today's market price for commodity)
Hedge point; we are generally hedging a spot position
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Dr David P Echevarria

9. FUNDAMENTALS OF FUTURES MARKETS
Defining Profits in Spot and Futures Contracts
Basis (b): Spot - Futures Price
Later: Increasing basis favors Long hedger/speculator, decreasing basis the short
Profit = - b (if held to T) P = -b + b (if offset prior to T)
Daily Price Movements
Each commodity has a maximum daily price change
Trading stops when a limit is reached
May reopen on authority of Exchange Floor Manager to maintain orderly market
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Dr David P Echevarria

10. FUNDAMENTALS OF FUTURES MARKETS
Opening a Futures Position (assuming you meet financial qualifications)
Determining Expectation
Long: expect prices to go up
Short: expect prices to go down
Depositing initial margin
Closing position before first day of expiration month (to avoid assignment)
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Dr David P Echevarria

11. TYPES OF HEDGES Interest Rate Futures Commodity futures
Currency Futures
Stock Index Futures
Single Stock Futures
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Dr David P Echevarria

12. HOMEWORK QUESTIONS
What is a forward contract? How does it differ from a futures contract?
What is arbitrage? How does the law of one price relate to arbitrage opportunities?
What is the difference between hedging and speculating?
How does the long position profit? The short position?
How are stock index futures settled?
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Dr David P Echevarria