1. FIN 4329 Derivatives Part 1: Futures Markets and Contracts

2. Copyright 2004, Dr. Jeffrey M. Mercer2 Introduction A forward contract is an agreement between two parties in which the buyer agrees to buy from the seller an underlying asset at a future date (called the expiration date) at a price established at the start of the contract (called the forward price). Both parties have commitments. The buyer is called the long - said to have taken the long position. The seller is called the short - said to have taken the short position. Note that no money changes hands until expiration.

3. Copyright 2004, Dr. Jeffrey M. Mercer3 Delivery and Settlement For a deliverable contract, at expiration the short delivers the u.a. and the long pays for it. This is called delivery settlement. For a cash-settlement contract, at expiration the two parties settle up based on the net cash value of the contract. Cash-settlement is used when delivery of the u.a. is impractical (e.g., the S&P 500 Index).

4. Copyright 2004, Dr. Jeffrey M. Mercer4 Default Risk Forward contracts are subject to default, in that one party might be unable/unwilling to carry through with their commitment. Only the party who has a “loss” can technically default (i.e., you would not walk away if you had a gain). How much is at risk? Only the “gain” coming to one party, not the forward price.

5. Copyright 2004, Dr. Jeffrey M. Mercer5 Termination by “Offsetting” One can effectively terminate a forward position by later taking a second, offsetting position. An initial long can be offset with a subsequent short, and vice versa. This can be done with the same party or with a different party.

6. Copyright 2004, Dr. Jeffrey M. Mercer6 Structure of Forward Markets Not a centralized market. Dealers (mostly big BHC’s and securities/investment firms) make a market and specialize. CSFB, Goldman Sachs, etc. Dealers transact with end users (those who wish to lay off risk) or other dealers so that they do not have large exposures.

7. Copyright 2004, Dr. Jeffrey M. Mercer7 Futures Like a forward contract, a futures contract is an agreement between two parties in which the buyer agrees to buy from the seller an underlying asset at a future date (called the expiration date) at a price established at the start of the contract (called the futures price). Key differences: Futures contracts are initiated (“opened”) on an organized futures exchange. Futures contract specifications are “standardized.” Futures contracts trade on an organized exchange (a secondary market); “pit trading.”

8. Copyright 2004, Dr. Jeffrey M. Mercer8 Public Standardized Transactions Forward contract transactions are private transactions. Futures contract transactions are recorded and reported – but not the direct identity of the parties. What are the “terms” of a forward or futures contract? Price –only term established by the two parties. All other terms (next slide) are established by the exchange – they are “standardized.”

9. Copyright 2004, Dr. Jeffrey M. Mercer9 Terms of a Futures Contract Specifications and grades of underlying asset. Expiration dates Months and days How far in the future Contract size (e.g., 5000 bushels) Price quotation unit Settlement specifics Delivery location Standardization creates liquidity. Traders can easily offset (buy if previously sold; sell if previously bought).

10. Copyright 2004, Dr. Jeffrey M. Mercer10 Daily Settlement Each futures exchange has a clearinghouse. Capitalized by clearing members. Guarantees all trades. Buyer to every seller. Seller to every buyer. Requires margin. Settles gains/losses every day. Called marking to market.

11. Copyright 2004, Dr. Jeffrey M. Mercer11 Margin and Marking to Market Margin Initial margin requirement Set by the clearinghouse. Based on risk exposure. Usually small. Creates leverage. Maintenance margin Lower than initial requirement Minimum end-of-day balance allowable (based on settlement price) before margin call Margin call; must bring balance back to initial level. Amount necessary is variation margin.

12. Copyright 2004, Dr. Jeffrey M. Mercer12 Delivery and Settlement Most futures contracts are offset before expiration. What happens if a contract is not terminated through offset? It depends on whether the contract calls for cash settlement or delivery. For a deliverable contract, at expiration the short delivers the u.a. and the long pays for it. This is called delivery settlement. For a cash-settlement contract, at expiration the two parties settle up based on the net cash value of the contract. Cash-settlement is used when delivery of the u.a. is impractical (e.g., the S&P 500 Index).

13. Copyright 2004, Dr. Jeffrey M. Mercer13 Short-Term Interest Rate Futures Primary short-term interest rate futures are Eurodollar futures (IMM of CME) Federal Funds futures (CBOT)

14. Copyright 2004, Dr. Jeffrey M. Mercer14 Eurodollar Futures Contracts The contract is based on the LIBOR rate on a 90-day Eurodollar deposit with $1,000,000 par (maturity) value. The futures contract is quoted as 100 minus the LIBOR rate (in percent) that is priced into the contract. 100 minus the Rate is called the IMM Index, so traders reference the IMM Index when quoting the futures “price.”

15. Copyright 2004, Dr. Jeffrey M. Mercer15 Eurodollar Futures Contracts  Say we see the IMM Index at 97.75. This implies that the discount rate on LIBOR being priced into the contract is 2.25%.  The actual futures price would then be

16. Copyright 2004, Dr. Jeffrey M. Mercer16 Eurodollar Futures Contracts So we can speak to the “price” of the futures contract in three separate ways: 1.The LIBOR rate itself (2.25%) 2.The IMM Index (97.75) 3.The actual contract price ($994,375)

17. Copyright 2004, Dr. Jeffrey M. Mercer17 Eurodollar Futures Contracts Note that as LIBOR declines, the IMM Index and the futures price increase. So eurodollar futures prices are inversely related to interest rates. For every one basis point move in LIBOR (say from 2.25% to 2.26%, or IMM Index from 97.75 to 97.74), the contract price changes by $25. The minimum tick size is one basis point, or $25.00 in price.

18. Copyright 2004, Dr. Jeffrey M. Mercer18 Eurodollar Futures Contracts The available expirations are the next two months plus March, June, September, and December out ten years. So at any point in time you can “lock in” floating rate payments tied to 3-month LIBOR. We can therefore observe the market’s expectation of 3-month LIBOR (i.e., LIBOR forward rates) from the futures market.

19. Copyright 2004, Dr. Jeffrey M. Mercer19 Federal Funds Futures Contracts The contract is based on the average daily fed funds overnight rate for the delivery month. The contract size is $5,000,000. The price is quoted as 100 minus the average daily fed funds overnight rate for the delivery month (e.g., a 2.25 percent rate is quoted as 97.75).

20. Copyright 2004, Dr. Jeffrey M. Mercer20 Federal Funds Futures Contracts The contract price, at a rate of 2.25%, would be The minimum tick size is one-half basis point, or $20.835 in price, calculated as (0.01)x(0.01)x(0.5)x(30/360)x($5,000,000).

21. Copyright 2004, Dr. Jeffrey M. Mercer21 Federal Funds Futures Contracts The available expirations are the next 24 months. Open interest in the nearby contract is almost 200,000 contracts. Cash settlement.

22. Copyright 2004, Dr. Jeffrey M. Mercer22 Intermediate- and Long-Term Interest Rate Futures Contracts The two most popular are T-note and T-bond Futures. T-notes have original maturities from 2 to 10 years. T-bonds have original maturities greater than 10 years. This is the only significant difference. The futures contracts are basically the same. We’ll focus on the T-bond contract.

23. Copyright 2004, Dr. Jeffrey M. Mercer23 T-Bond Futures Contracts The contract is based on the delivery of a U.S. T- bond with any coupon rate but with a remaining maturity of at least 15 years, and $100,000 par value. At any time, there are many different issues, with very large outstanding principal balances, that will satisfy this condition. That is, many different bonds are “deliverable.” The short, then, will want to deliver the “cheapest” bond he can find.