1. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. ■provide a background on financial futures contracts ■explain how interest rate futures contracts are used to speculate or hedge based on anticipated interest rate movements ■explain how stock index futures contracts are used to speculate or hedge based on anticipated stock price movements ■explain how single stock futures are used to speculate on anticipated stock price movements 13 Financial Futures Markets Chapter Objectives 1

2. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Financial Futures  A financial futures contract is a standardized agreement to deliver or receive a specified amount of a specified financial instrument at a specified price and date.  Financial futures contracts are traded on organized exchanges, which establish and enforce rules for such trading.  The operations of financial futures exchanges are regulated by the Commodity Futures Trading Commission (CFTC). 2

3. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Financial Futures 1.Popular Futures Contracts  Interest Rate Futures  Debt securities such as Treasury bills, Treasury notes, Treasury bonds, and Eurodollar CDs.  Settlement dates occur Mach, June, September, and December  Stock Index Futures  Allows for the buying and selling of a stock index for a specified price at a specified date  There are various index future contracts. (Exhibit 13.1) 3

4. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exhibit 13.1 Stock Index Futures Contracts 4 Source: Republished with permission of Dow Jones & Company, Inc., from The Wall Street Journal, January 7, 2009, C9; permission conveyed through the Copyright Clearance Center, Inc.

5. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Financial Futures 2.Markets for Financial Futures  Futures Exchanges  Provide an organized marketplace where standardized futures contracts can be traded.  Clear, settle, and guarantee all transactions  Most financial futures contracts in the U.S. are traded through the CME Group, a merger of the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME) as of July 2007.  Over-the-Counter Market  A financial intermediary finds a counterparty or serves as the counterparty.  More personalized and can be tailored to specific preferences 5

6. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Financial Futures 3.Purpose of Trading Financial Futures  Speculators in financial futures markets take positions to profit from expected changes in the futures prices.  Hedgers take positions in financial futures to reduce their exposure to future movements in interest rates or stock prices. 6

7. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Background on Financial Futures 4. Trading Requirements  Customers open accounts at brokerage firms and establish margin deposits with the brokers. The initial margin is between 5 and 18% of a futures contract’s full value.  The futures contract price changes on a daily basis, its value is “ marked to market.”  Type of Orders market order, the trade is executed at the prevailing price. limit order, the trade is executed if the price is within the limit specified by the customer. 7

8. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Rate Futures Contracts  Interest rate futures contracts specify a face value of the underlying securities, a maturity of the underlying securities, and the settlement date when delivery would occur.  There is a minimum price fluctuation for each contract.  Speculating in Interest Rate Futures: future movements in interest rates can affect the treasury security values and thus prices of interest rate futures.  Most buyers or sellers offset their positions by the settlement date. 8

9. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculating with T-bill futures, example 1 In February, Jim Sanders purchased one T-bill futures contract with a price of 94.00 ( a 6 percent discount) and the price on the settlement date was 94.60 ( a 5.1 percent discount). The par value of a T-bill futures contract is $1 million. The profit from this strategy is 9

10. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculating with T-bill futures, example 2 In February, Jim Sanders purchased one T-bill futures contract with a price of 94.00 ( a 6 percent discount) and the price on the settlement date was 92.50 ( a 7.5 percent discount). The par value of a T-bill futures contract is $1 million. The profit from this strategy is 10

11. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculating with T-bond futures A speculator purchased a futures on Treasury bond at a price of 90-00. One month later, the speculator sells the same contract at 92-10. Given the par value of the contract is $100,000, how much is the profit? (92+10/32)%x100,000 - (90+00/32)%x100,000 =$2,312.50 1/32: minimum price change 11

12. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Interest Rate Futures Contracts Hedging with Interest Rate Futures In the short run, an institution may consider using financial futures to hedge its exposure to interest rate movements.  Using Interest Rate Futures to Create a Short Hedge - Financial institutions commonly take a position in interest rate futures to create a short hedge, which represents the sale of a futures contract.  Cross-Hedging  The use of a futures contract on one financial instrument to hedge a position in a different financial instrument.  The effectiveness of a cross-hedge depends on the correlation between the changes in market values of the two instruments. 12

13. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short Hedge example 1 A commercial bank currently holds a large amount of long-term corporate bonds. Its primary source of funds is short-term deposits. The bank will be adversely affected if interest rate rises in the near future. It can hedge against the interest rate risk by selling Treasury bond futures. 13

14. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Short Hedge example 2 Charlotte Insurance Co. plans to sell its Treasury bond holdings in six months for $5 million at that time. It is concerned that interest rates might increase over the next several months, which would reduce the market value of the bonds by the time they are sold. To hedge this risk, Charlotte sells 50 Treasury bond futures contract with a par value of $5 million ($100,000 per contract) for 98-16. Suppose that the actual price of the future contract declines to 94-16 because of an increase in interest rates on the date when Charlotte sells its bond holdings. Charlotte can close out its short futures position by purchasing contracts identical to those it has sold. The profits would be 14

15. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Long Hedge example A government securities dealer plans to buy long-term bonds in a few months. If the dealer is concerned that prices of these securities will rise before the time of their purchases, he may purchase Treasury bond futures contracts. These contracts lock in the price at which bonds can be purchases. 15

16. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Index Futures  The purchase of an S&P 500 futures contract obligates the purchaser to purchase the S&P 500 index at a specified settlement date for a specified amount.  Stock index futures contracts have settlement dates on the third Friday in March, June, September, and December.  The securities underlying the stock index futures contracts are not actually deliverable, so settlement occurs through a cash payment.  Like other financial futures contracts, stock index futures can be closed out before the settlement date by taking an offsetting position. 16

17. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Index Futures Speculating in Stock Index Futures  Stock index futures can be traded to capitalize on expectations about general stock market movements.  Speculators who expect the stock market to perform well before the settlement date may consider purchasing S&P 500 index futures.  Speculators who expect the stock market to perform poorly before the settlement date may consider selling S&P 500 index futures. 17

18. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Speculating in stock index futures Boulder company anticipates a large jump in stock market prices before December, so it decides to purchase S&P500 index futures. The futures price on that index with a December settlement date is 1500. The value of one future contract is $250 times the index. Assume that the index rises to 1600 on the settlement date. How much is the profit for each contract? 18

19. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Stock Index Futures Hedging with Stock Index Futures  Stock index futures are used to hedge the market risk of an existing stock portfolio. 19

20. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Hedging with stock index futures example 1 Glacier Stock Mutual Fund expects the stock market to decline temporarily, causing a temporary value decline in its stock portfolio. The fund could sell its stocks with the intent to repurchase them in the near future, but this would incur excessive transaction costs. A more efficient solution is to sell stock index futures. if the stock market declines as expected, Glacier will generate a gain when closing out the stock index futures position, which will somewhat offset the loss on its stock portfolio. 20

21. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Hedging with 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 … 21

22. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Single Stock Futures traded in OneChicago  Agreements to buy or sell a specified number of shares of a specified stock on a specified future date.  They are regulated by the Commodity Futures Trading Commission and the Securities and Exchange Commission.  Settlement dates are on the third Friday of the delivery month on a quarterly basis (March, June, September, and December) for the next five quarters as well as for the nearest two months.  100 shares for each contract. 22

23. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Globalization of Futures Markets Currency Futures Contracts  A standardized agreement to deliver or receive a specified amount of a specified foreign currency at a specified price (exchange rate) and date.  The settlement months are March, June, September, and December.  Purchasers of currency futures contracts can hold the contract until the settlement date and accept delivery of the foreign currency at that time, or they can close out their long position prior to the settlement date by selling the identical type and number of contracts before then. 23

24. © 2016 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Homework assignment 11 Chapter 13 Questions and applications: 4, 7, 8 Problems: 1,2,3,4,5,6,7 24