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FUTURES

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Title: FUTURES


1
  • FUTURES
  • FORWARDS

2
Introduction
  • The futures market enables various entities to
    lessen price risk, the risk of loss because of
    uncertainty over the future price of a commodity
    or financial asset
  • The two major market participants are the hedger
    and the speculator
  • A futures contract is a legally binding agreement
    to buy or sell something in the future
  • The person who initially sells the contract
    promises to deliver a quantity of a standardized
    commodity to a designated delivery point during
    the delivery month the other party to the trade
    promises to pay a predetermined price for the
    goods upon delivery

3
Forward and Futures
  • Forward contract two parties agree to exchange
    an asset on a future date at a price set today.
  • no collateral posted
  • Tailor-made
  • OTC
  • Futures Contract a highly liquid version of a
    forward contract.
  • margin account settlement price
  • Futures commission merchant
  • Trading pit
  • Exchange clearinghouse

4
Forward and Futures Trading Mechanics
5
Trading Mechanics
  • Most futures contracts are eliminated before the
    delivery month
  • The speculator with a long position would sell a
    contract, thereby canceling the long position
  • The hedger with a short position would buy a
    contract, thereby canceling the short position
  • Example
  • Suppose a speculator purchases a July soybean
    contract at a purchase price of 6.12 per bushel.
    The contract is for 5,000 bushels of No. 2 yellow
    soybeans at an approved delivery point by the
    last business day in July.
  • Upon delivery, the purchaser of the contract must
    pay 6.12(5,000) 30,600.
  • At the delivery date, the price for soybeans is
    6.16. This equates to a profit of 6.16 - 6.12
    0.04 per bushel, or 200. If the spot price on
    the delivery date were only 6.10, the purchaser
    would lose 6.12 - 6.10 0.02 per bushel, or
    100.

6
Ensuring the Promise is Kept
  • In 1974, Congress passed the Commodity Exchange
    Act establishing the Commodity Futures Trading
    Commission (CFTC)
  • Ensures a fair futures market
  • A self-regulatory organization, the National
    Futures Association was formed in 1982
  • Enforces financial and membership requirements
    and provides customer protection and grievance
    procedures
  • The Clearing Corporation ensures that contracts
    are fulfilled
  • Becomes party to every trade
  • Ensures the integrity of the futures contract
  • Assumes responsibility for those positions when a
    member is in financial distress

7
Some contracts size and margin requirements
  • Good faith deposits (or performance bonds) are
    required from every member on every contract to
    help ensure that members have the financial
    capacity to meet their obligations
  • Selected Good Faith Deposit Requirements
  • Data as of January 2, 2004

8
Quotations
9
Types of Orders
  • A broker in commodity futures is a futures
    commission merchant (not the individual who
    places the order)
  • When placing an order, the client should specify
    the type of order
  • A market order instructs the broker to execute a
    clients order at the best possible price at the
    earliest opportunity
  • With a limit order, the client specifies a time
    and a price
  • E.g., sell five December soybeans at 540, good
    until canceled
  • A stop order becomes a market order when the stop
    price is touched during trading action
  • When executed, stop orders close out existing
    commodity positions
  • E.g., a short seller may use a stop order to
    protect himself against rising commodity prices

10
Market Participants
  • A hedger is someone engaged in a business
    activity where there is an unacceptable level of
    price risk
  • A processor earns his living by transforming
    certain commodities into another form? e.g., a
    soybean processor buys soybeans and crushes them
    into soybean meal and oil
  • A speculator finds attractive investment
    opportunities in the futures market and takes
    positions in futures in the hope of making a
    profit (rather than protecting one). The
    speculator is willing to bear price risk. For
    example, a position trader is someone who
    routinely maintains futures positions overnight
    and sometimes keep a contract for weeks a day
    trader closes out all his positions before
    trading closes for the day
  • Scalpers (or locals) are individuals who trade
    for their own account, making a living by buying
    and selling contracts. Scalpers help keep prices
    continuous and accurate.
  • Example Scalping With Treasury Bond Futures
  • You just sold 5 T-bond futures to ZZZ for 77
    31/32. Now, a sell order for 5 T-bond futures
    reaches the pit and you buy them for 77 30/32.
    Thus, you just made 1/32 on each of the 5
    contracts, for a dollar profit of
  • 1/32 x 100,000/contract x 5 contracts 156.25

11
ClearingHouse Matching Trades
  • Every trade must be cleared by or through a
    member firm of the Board of Trade Clearing
    Corporation
  • Each trader is responsible for making sure his
    deck promptly enters the clearing process
  • After the Clearing Corporation receives trading
    cards
  • Mismatches (out trades) result in an Unmatched
    Trade Notice being sent to each clearing member
  • After resolving all out trades, the computer
    prints a daily Trade Register
  • Shows a complete record of each clearing members
    trades for the day
  • Contains subsidiary accounts for each customer
    clearing through the firm
  • Commodity prices may move so much in a single day
    that good faith deposits for many members are
    seriously eroded before the day ends.
  • The president of the Clearing Corporation may
    issue a market variation call for members to
    deposit more funds into their account

12
Dealing with Margins
  • Assume you are short 2 December SP 400 futures
    contracts for 924.5 (an SP 400 contract is for
    500 times the index). The total value of the
    position is 2 times 500 times 924.5 or 924,500.
    Let s assume that your initial margin is 5 or
    46,225 and your maintenance margin is 4.5, that
    is 41,602.5. Lets look at when a margin call
    will occur

13
Margins
14
Some notations
  • Futures Price the price, set today, at which
    the asset will be traded in the future
  • At Maturity futures price spot price
  • Trade agreements
  • Buy a futures, you are long in the futures market
    ()
  • Sell a futures, you are short in the futures
    market(-)

15
Speculating with futures
  • Assume that a buyer and seller agree on a futures
    price of 45. At expiration, the underlying
    security is priced at 53.
  • Buyer makes 8.00
  • Seller loses 8.00
  • At t0, Buyer went long on the contract at 45
  • At maturity, Buyer bought from seller at 45and
    sold on the spot at 53 to realize the profit of
    8.
  • At t0, seller went short on the contract at 45
  • At maturity, seller rushed to buy at 53 on the
    spot, and sold at a committed 45 to buyer, to
    lose 8.

16
Hedging
  • Futures contracts allow buyers and manufacturers
    to lock into prices and costs, respectively
  • If a firm wants gold, it buys contracts,
    promising to pay a set price in the future (long
    hedge)
  • A gold mining company sells contracts, promising
    to deliver the gold (short hedge)
  • Hedge - a trading strategy in which derivative
    securities are used to reduce or completely
    offset a counterparty's risk exposure to an
    underlying asset.
  • Long hedge - created by supplementing a short
    spot holding with a long futures position.
  • Short hedge - holding a short futures position
    against the long position on the spot.

17
Example
  • A farmer expects to harvest 40,000 bushels of
    wheat in August. It costs him about 3.05 a
    bushel to plant and harvest the crop. An August
    futures price of 3.45 is available. How can the
    farmer lock the price of his crop?

18
Solution
  • Build a selling (short) hedge sell 8 of these
    August futures contracts (40,000/5,000).

19
An other example
  • You are managing a 100,000 (face value)
    portfolio in T-BONDS priced at 98-10 or
    98,312.5. In June, you are concern with a
    forthcoming increase in interest rates (within
    the next 6 months, around Novembermay be). A
    December T-bond futures priced at 97-00 (97,000)
    is available. On November 15th interest rates
    increase and T-bonds drop to 96-08 the December
    futures contract price drops to 95-10.

20
Solution
  • You enter into a short hedge to lock the value
    of your portfolio for the next seven month.

21
Another Example
  • you are managing 5 million of common stock
    portfolio. You are concern that the market will
    go down in the next three months. The current
    3-month SP400 index futures is selling at 200.
    The price of 1 contract is 500 per index point
    Assume that the portfolio value falls to 4
    million two months after and that the SP400
    index futures falls simultaneously at 170.

22
Solution
  • you are long in the cash market to protect
    yourself, you will go short in the futures market
    (short hedge) if the value of one contract is
    100,000 (200 x 500), you need 50
    (5,000,000/100,000) contracts to hedge the
    whole 5,000,000.

23
Imperfect hedge
  • In practice, a contract on a similar asset may
    not exist----gtuse the closest proxy!
  • For bond portfolio, a T-bond futures
  • For Stock portfolio, an index futures
  • For a combination, treat each asset class
    independently

24
Imperfect hedges and bond portfolio
  • The objective of hedging is to select a hedge
    ratio (D) such as
  • (change in S) hedge ratio X (change in F) 0
  • or
  • hedge ratio D (change in S) / (change in F)

25
Imperfect hedges and bond portfolio(continued)
26
Imperfect hedges and bond portfolio(continued)
27
Example
  • suppose an investment banker underwrites the
    issue of a bond that will be sold in 3 months. He
    has set the indenture and expect to sell the
    animal at par! The total issue amounts to
    10,000,000 (or 10,000 bonds). Yet, he is
    concerned about a rise in interest rates.

28
Solution
  • He short-hedges the new issue in the T-BOND
    futures market. He knows that the bond is far
    from being a T-BOND, but futures on this bond are
    not traded. Knowing that a T-Bond futures
    contract covers 100,000, he finds that the right
    amount of contracts to be sold to hedge the new
    issue should be 82 contracts

29
Solution (continued)
30
Example
  • You manage a fund you plan to sell 100,000,000
    of a type of bonds in 2 months from now to
    reallocate the assets of the portfolio.

31
Solution
  • You build a short hedge by selling 1,111 T-Bond
    futures

32
Dealing With Coupon Differences
  • To standardize the 100,000 face value T-bond
    contract traded on the Chicago Board of Trade, a
    conversion factor is used to convert all
    deliverable bonds to bonds yielding 6

33
Hedging With Interest Rate Futures
  • The hedge ratio is
  • The number of contracts necessary is given by

34
Futures Hedging Example
  • A bank portfolio holds 10 million face value in
    government bonds with a market value of 9.7
    million, and an average YTM of 7.8. The weighted
    average duration of the portfolio is 9.0 years.
    The cheapest to deliver bond has a duration of
    11.14 years, a YTM of 7.1, and a CBOT correction
    factor of 1.1529.
  • An available futures contract has a market price
    of 90 22/32 of par, or 0.906875. What is the
    hedge ratio? How many futures contracts are
    needed to hedge?

35
On the equity side Index futures
  • The fastest growing segment of the futures market
    is in financial futures
  • Stock index futures are similar in every respect
    to a traditional agricultural contract except for
    the matter of delivery
  • Index futures settle in cash rather than by
    delivery of the underlying asset
  • There is no actual delivery mechanism at
    expiration of an SP 500 futures contract
  • You actually deliver the dollar difference
    between the original trade price and the final
    price of the index at contract termination

36
Synthetic Index Portfolios
  • Large institutional investors can replicate a
    well-diversified portfolio of common stock by
    holding
  • A long position in the stock index futures
    contract and
  • Satisfying the margin requirement with T-bills
  • The resulting portfolio is a synthetic index
    portfolio
  • The futures approach has the following advantages
    over the purchase of individual stocks
  • Transaction costs will be much lower on the
    futures contracts
  • The portfolio will be much easier to follow and
    manage
  • As time passes, the difference between the cash
    index and the futures price will narrow
  • At the end of the futures contract, the futures
    price will equal the index (basic convergence)

37
Imperfect hedge and equity portfolio
Using Futures Contracts to Hedge Portfolios You
are the manager of an equity portfolio. You are
bullish in the long term, but anticipate a
temporary market decline. How can you use
futures contracts to hedge your stock portfolio?
If you are long stock, you should be short
futures. You need to calculate the number of
contracts necessary to counteract likely changes
in the portfolio value.
  • In a perfect hedge
  • N portfolio value/contract value
  • In reality, there are only index futures and your
    portfolio is not exactly the same as the index!
  • Nportfolio value/contract value x ?portfolio

38
Example
  • Suppose that in mid-December you own a portfolio
    worth 3,243,750 you expect the market to plunge
    within the next 6 months thus, you sell June SP
    500 futures contracts which currently trade at a
    settlement price of 617.00. The value of a single
    contract is 308,500--i.e., 500 x 617-- your
    portfolio has a beta of 1.15 with the SP400
    then, you decide to short 12 contracts, as you
    are long in the equity market

39
Hedge Ratio example
  • Determining the Factors for A Hedge
  • Suppose the manager of a 75 million stock
    portfolio (with a beta of 0.9 and a dividend
    yield of 1.0) wants to hedge using the December
    SP 500 futures.
  • On the previous day, the SP 500 closed at
    1,484.43, and the DEC 00 SP 500 futures closed
    at 1,517.20.
  • The value of the futures contract is 250 x
    1,517.20 379,300
  • And the hedge ratio is 178 contracts

40
The Market Falls
  • Using the Hedge in A Falling Market
  • Assume the SP 500 index falls 5, from 1,484.43
    to 1,410.20 after four months.
  • Given beta, the portfolio should have fallen by
    5.0 x 0.9 4.5, which translates to
    3,375,000. However, you receive dividends of 1
    x .333 x 75,000,000 250,000.
  • If you sold 178 contracts short at 1,517.20,
    your account will benefit by (1,517.20
    1,410.20) x 250 x 178 4,761,500.
  • The combined positions (stock, dividends, and
    futures contracts) result in a gain of 1,636,500.

41
The Market Rises
  • Using the Hedge in A Rising Market
  • Assume the SP 500 index rises from 1,484.43 to
    1,558.70 after four months.
  • Given beta, the portfolio should have advanced
    by 5.0 x 0.9 4.5, which translates to
    3,375,000. You still receive dividends of 1 x
    .333 x 75,000,000 250,000.
  • If you sold 178 contracts at 1,517.20, your
    account will lose (1,517.20 1,558.70) x 250 x
    178 1,846,750.
  • The combined positions (stock, dividends, and
    futures contracts) result in a gain of
    1,778,250.

42
The Market is Unchanged
  • Using the Hedge in An Unchanged Market
  • Assume the SP 500 index remains at 1,484.43
    after three months.
  • There is no gain on the stock portfolio.
    However, you still receive dividends of 1 x .333
    x 75,000,000 250,000.
  • If you sold 178 contracts short at 1,517.20,
    your account will benefit by (1,517.20
    1,484.50) x 250 x 178 1,455,150.
  • The combined positions (stock, dividends, and
    futures contracts) result in a gain of
    1,705,150.

43
Speculation Active bond portfolio management
Increasing Duration With Futures
  • Extending duration may be appropriate if active
    managers believe interest rates are going to fall
  • Adding long futures positions to a bond portfolio
    will increase duration

44
Example
  • A portfolio has a market value of 10 million,
    an average yield to maturity of 8.5, and
    duration of 4.85. A forecast of declining
    interest rates causes a bond manager to decide to
    double the portfolios duration. The cheapest to
    deliver Treasury bond sells for 98 of par, has a
    yield to maturity of 7.22, duration of 9.7, and
    a conversion factor of 1.1223. Determine the
    number of futures contracts needed to double the
    portfolio duration.

45
Speculation Active management-- Adjust Portfolio
Beta
46
Example
  • You have a 25 million equity portfolio
    consisting of 22.5M in stocks and 2.5M in
    T-bills. Current beta of equity portion is 0.95.
    You want to increase it to 1.10. An SP400
    futures contract is quoted at 476.6. Thus, You
    need to be long 26 contracts
  • N1.1-(22.5/25) X .95 X 25,000,000/(500 X
    476.6)25.7
  • It is positive thus buy 26 contracts (you cannot
    buy 25.7 contracts).

47
Adjusting Market Risk Example
  • Determining the Number of Contracts Needed to
    Increase Market Exposure
  • Suppose the manager of a 75 million stock
    portfolio with a beta of 0.9 would like to
    increase market exposure by increasing beta to
    1.5. Yesterday, DEC 00 SP 500 futures closed at
    1517.20
  • How can the manager use futures to accomplish
    this goal, assuming the composition of the stock
    portfolio remains unchanged?
  • The manager should go long futures and hold them
    with the stock portfolio. Specifically, he should
    purchase 119 SP 500 futures contracts

48
Speculation Tactical Changes using Futures
  • Investment policy statements may give the
    portfolio manager some latitude in how to split
    the portfolio between equities and fixed income
    securities
  • The portfolio manager can mix both T-bonds and
    SP 500 futures into the portfolio to adjust
    asset allocation without disturbing existing
    portfolio components

49
Example Initial Situation
  • Portfolio market value 175 million
  • Invested 82 in stock (average beta 1.10) and
    18 in bonds (average duration 8.7 average YTM
    8.00)
  • The portfolio manager wants to reduce the equity
    exposure to 60 stock
  • Determine
  • How many contracts will remove 100 of each
    market and interest rate risk
  • What percentage of this 100 hedge matches the
    proportion of the risk we wish to retain
  • Some data
  • Stock Index Futures ?September settlement
    1020.0
  • Treasury Bond Futures? September settlement
    91.05
  • Cheapest to deliver bond
  • Price 95
  • Maturity 18 years
  • Coupon 9
  • Duration 8.60
  • Conversion factor 1.3275

50
Initial Situation
51
Bond Adjustment
Thus, the manager should buy 521 T-bond futures
52
Stock Adjustment
  • For this portfolio, the hedge ratio is

53
In sum
  • The portfolio manager can change the asset
    allocation from 82 stock, 18 bonds to 60
    stock, 40 bonds by
  • Buying 521 T-bond futures and
  • Selling 166 stock index futures

54
Neutralizing Cash
  • It is harder to beat the market with the
    downward bias in relative fund performance due to
    cash
  • Cash can be neutralized by offsetting it with
    long positions in stock index futures
  • Cash can be neutralized by offsetting it with
    long positions in interest rate futures

55
Example
  • An all-equity fund has a benchmark that follows
    the SP500.
  • Fund size500M
  • SP500 futures1200
  • Beta1
  • SP500 return11.5 (long run return)
  • Cash return2.5 (long run return)
  • Allocation 95 Equity, 5 cash
  • Cash need to be on hand in case of investors
    redemptions.
  • The fund receives periodic contributions. They
    have a problem cash does return less than equity
    and over long period of time, large cash
    positions biases the performance of a portfolio.
  • ?E(Rp)95 x 11.55 x 2.511.05versus 11.5
  • One can offset this 45 BP loss by being long on
    SP500 futures?increase the beta of the portfolio
    by neutralizing the cash portionI.e.,
  • N(Cash Portfolio size)/(futures size) x beta
    (5 x 500M)/(1200 x 250) x183
  • By buying 83 SPX futures, the 95 equity and 5
    cash portfolio will behave exactly like a 100
    equity portfolio
  • 475M in stock25M in cash 83 in stock futures
    500M in stocks
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