Futures Markets

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Futures Markets

• History- Fares in the Middle Ages
• Chicago Board of Trade (1848)
• (www.CBT.com)
• Forward Mkts vs. Futures Mkts.
• - a futures contract is a standardized
  forward contract.
• - grade, place time of delivery,quantity are
  all standardized in a futures contract

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Corn Futures Example

• Trading Unit - 5,000 bu
• Deliverable Grades No. 2 Yellow
• Price Quote Cents and quarter-cents/bu
• Tick Size 1/4 cent/bu (12.50/contract)
• Contract Months Nov, Dec, Jan, Mar, May,
  Jul, Sep
• Ticker Symbol C

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Futures Quote
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Futures Markets (Terms)

• Settle Price
• Open Interest
• Futures Positions
• Long (buy a contract)
• Short (sell a contract)

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• Kinds of Futures Contracts
• Agricultural Corn, wheat, etc.
• Commodity Oil, Gold, etc.
• Currency British Pound, etc.
• Interest Rate T-Bills, T-Bonds, etc.
• Stock Index SP 500, DJ Index, etc.
• Futures Exchanges
• Chicago Board of Trade (CBOT)
• Chicage Mercantile Exhange (CME)

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• Margin Positions - Every Exchange sets
• specific margin requirements for each contract
  of its traders.
• Margins Customer margins are amounts that
  individual buyers and sellers of futures
  contracts are required to deposit with brokers.
  Margins are determinted on the basis of market
  risk and contract value.

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Margins and Marking to Market

• CBOT Corn Contract 5,000 bu
• Initial Margin per contract 473
• Maintenance Margin 350
• Buy 1 Contract _at_ 300/cents per bu.
• Contract Value 5,000 3 15,000
• Initial Margin 475
• Leverage 96.8

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• Marking to Market Example
• Day Price Value Equity Margin Excess
• 1 3.00 15,000 475
  475 -
• 2 3.02 15,100 575 350
  225
• 3 2.99 14,950 425 350
  75
• 4 2.95 14,750 225 350
  (125)
• Contract Value Price 15,000 bu
• Deposit Margin Call 125
• 
  350

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Futures Market Participants

• Speculators
• Hedgers
• Uses of Futures (hedging examples)
• Farmer is long in commodity.
• Lock in the price with a short position
• If P rises, farmer gains, but short position
  loses
• If P falls, farmer loses, but short position
  gains.

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• Merchant is short in the commodity
• Lock in the price with a long position
• If P rises, merchant loses, but long position
  gains
• If P falls, merchant gains, but long position
  loses.
• Corportation wants to guarantee the cost of funds
  on a loan in the future.
• Corp. is long on debt, i.e., it expects to sell
  debt in the future and fears the price will fall
  (rates will rise).
• Corp. should take a short position in debt.

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• SL wants to make a long-term loan to a
  developer, financed by short-term CDs.
• Once the loan is made, the SL is long on debt
  because it must sell it in the future. It can
  hedge by going short on debt in the futures
  market.
• U.S. Corp is planning to invest in the U.K. next
  year. It is short Pounds, because it must buy
  them next year. It can hedge by buying a futures
  contract today (taking a long position in Pounds).

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• Stock Portfolio Manager fears a fall in the stock
  market, but for tax reasons does not want to
  sell. The fund manager is long on stocks. He
  can hedge his position by taking a short position
  (selling) stock index futures.
• Pricing Stock Index Futures
• Program Trading (or Index Arbitrage) is
  another use of futures.
• When futures mature then Pf PS

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• But prior to expiration, Pf gt PS or Pf lt PS
• If, however, (Pf - PS) / PS gt kRF then traders
  will arbitrage between the two markets.
• If Pf gt PS , they sell futures and buy the spot.
• If Pf lt PS , they buy futures and sell the spot.
• In either case, they will earn a risk-free return
  greater than kRF .

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• Program Trading Example
• Suppose SP 500 futures is at 1,435 with 90 day
  to expiration.
• At the same, the spot price of the SP 500 is
  1,400
• Then (1,435-1,400)/1,400 0.025 and
• 0.025 (360/90) 10 gt kRF
• In this case, the trader would sell futures and
  buy the spot market. At expiration, when Pf
  PS, the trader would reverse.

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Net Worth Hedging

• A bank can use futures to protect its balance
  sheet against changes in interest rates
• Suppose
• Assets 1,000,000 with Duration 5
• Liab. 950,000 with Duration 3
• Duration of Assets gt Duration of Liabilities
• If rates fall, equity rises, but if rates rise,
  equity falls

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• This bank is exposed to interest rate risk. It
  can sell (go short) in interest rate futures to
  eliminate its risk. If it sells futures, then
  when rates rise it makes a profit in the futures
  market.
• Duration Rule (page 346)
• DG MVA DA - MVL DL MVF DF
• If DG gt 0, then bank gains when rates fall.
• If DG lt 0, then bank loses when rates fall.
• If DG 0, then bank is hedged against rate
  changes.

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Relation of Spot Futures Prices

• The futures price (Pf) cant exceed the spot
  price (PS) by any more than the cost of carry (c)
  
• Pf PS lt c
• Implied Cost of Carry c r s
• Pf PS (1 r s) If you are willing to
  assume r you can compute s.

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Risks in Using Futures

• Basis Risk - the futures contract may not move in
  perfect accord with what is being hedged.
• Margin Risk - when a futures position moves
  against you, you must put up margin dollars.

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• Homework Problems 11-11, 11-12, 11-14