Chapter 13

Financial Futures Markets

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 Chapter Outline
n Background on financial futures
¨ Interpreting financial futures tables
¨ Valuation of financial futures

n Speculating with interest rate futures

n Closing out the futures position
n Hedging with interest rate futures
n Risk of trading futures contracts
n Institutional use of futures markets
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Background on Financial Futures
n 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
¨ The buyer of a futures buys the instrument while the seller
delivers the instrument
n Futures are traded on organized exchanges
¨ The exchanges clear, settle, and guarantee all transactions that
occur on the exchange
n Futures are regulated by the Commodity Futures
Trading Commissions (CFTC)
¨ Approves futures contracts and imposes regulations
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Background on Financial Futures (cont’d)
n Interest rate futures are on debt securities such
as T-bills, T-notes, T-bonds, and Eurodollar CDs
n Stock index futures are on stock indexes
¨ Settlement dates are in March, June, September, and
December
¨ Most financial futures are traded on the Chicago
Board of Trade or the Chicago Mercantile Exchange

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Mechanics of Futures Markets
n Futures contracts are available on a wide range of
assets: stocks, bonds, interest rates, currencies, corn,
meat, oil..
n Futures are exchange traded products. Some futures
exchange websites:
¨ Chicago Mercantile Exchange: http://www.cmegroup.com/
¨ InterContinental Exchange (www.theice.com),
¨ Eurex (www.eurexchange.com),
¨ BM&F BOVESPA (www.bmfbovespa.com.br)
¨ Tokyo Financial Exchange (www.tfx.co.jp).
¨ Sydney Futures Exchange: (www.asx.com.au)
Background on Financial Futures (cont’d)
n Purpose of trading financial futures
¨ Speculate on prices of securities or to hedge existing exposure
to security price movements
¨ Speculators: take positions to profit from expected changes in
the price of futures contracts over time
n Day traders: attempt to capitalize on price movements during a
single day
n Position traders: maintain their futures positions for longer periods
of time
¨ Hedgers: to reduce their exposure to future movements in
interest rates or stock prices

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Background on Financial Futures
(cont’d)
n Electronic trading
¨ TheChicago Mercantile Exchange established
GLOBEX that compliments its floor trading
n Allows for around the clock and weekend trading
¨ The Chicago Board Options Exchange implemented
a fully electronic futures exchange in 2004

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Background on Financial Futures (cont’d)
n Steps involved in trading futures
¨ Members of a futures exchange are either:
n Commission brokers: execute orders for their customers and
are often employed by brokerage firms
n Floor traders (locals): trade futures contracts for their own
account
¨ Many types of futures contracts now trade over the
counter
n Are more personalized and can be tailored to the specific
preferences of the parties involved

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Background on Financial Futures
(cont’d)
n Steps involved in trading futures (cont’d)
¨ Customers must establish margin deposits with their brokers
n Initial margin is typically between 5 and 18 percent of a futures’
full value
¨ A futures contract price is “marked to market” daily
n Customers may receive a margin call if the value moves in an
unfavorable direction
¨ A market order is executed at the prevailing price of the futures
contract
¨ A limit order is executed only if the price is within the limit
specified

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Background on Financial Futures
(cont’d)
n Steps involved in trading futures (cont’d)
¨ How orders are executed
n Brokerage firms communicate customers’ order to
telephone stations located near the trading floor
n Floor brokers accommodate orders
n When two traders on the floor reach an agreement through
open outcry, the information is transmitted to the customers
n Floor brokers receive transaction fees in the form of a bid-
ask spread
n The futures exchange acts as a clearinghouse

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Financial Futures Tables
n Example of Treasury bill futures quotations:
Discount

Open High Low Settle Change Settle Change Open

Sept 2005 93.80 94.05 93.80 94.05 +.28 5.95 –.28 2,519

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Characteristic of Treasury Bond Futures Treasury Note Futures
Futures Contract
Size $100,000 face value $100,000 face value

Deliverable grade Treasury bonds maturing at least 15 Treasury notes maturing at least
years from date of delivery is not 6.5 years but not more than 10
callable; coupon rate is 8% years from the first day of the
delivery month; coupon rate is
6%
Price quotation In points ($1,000) and thirty-seconds In points ($1,000) and thirty-
of a point seconds of a point

Minimum price One thirty-second (1/32) of a point, One thirty-second (1/32) of a

fluctuation or $31.25 per contract point, or $31.25 per contract

Daily trading limits Three points ($3,000) per contract Three points ($3,000) per
above or below the previous day’s contract above or below the
settlement price previous day’s settlement price

Settlement months March, June, September, December March, June, September,

December

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n Open interest: the number of contracts outstanding
¨ equal to number of long positions or number of short
positions
n Trading volume: the number of contracts traded in one day

Time Trading Activity Trading Open Interest

Volume
Jan 1 A buys 1 futures contract and B sells 1 futures 1 1 (buy/sell new)
contract
Jan 2 C buys 5 futures contracts and D sells 5 futures 5 6 (buy/sell new)
contracts
Jan 3 A sells his 1 futures contract and D buys 1 futures 1 5 (A,D: settle 1)
contract
(B:1S, D:4S, C:5L)
Jan 4 E buys 5 futures contracts from C who sells his 5 5 5 (E: buy
futures contracts new/C: settle)

(B:1S, D:4S, E:5L)

— Settlement price: the price just before the closing time
each day
– used for the daily settlement process
— Closing out positions prior to the expiry date: by taking
the opposite position to the original (offsetting)
— Closing out at the expiry date: physical delivery or cash
settlement (margin operations).
— Specification of a futures contract:
- The underlying asset
- The contract size
- Delivery arrangements: physical delivery or cash
- Price quotes/limits
- Margin requirements
Marking-to-market of futures
o A futures contract is settled daily rather than at the end
of its life
o Losses and profits are settled to the accounts of the
buyer and the seller at the end of each day.
o How?
o Margin: is cash or marketable securities deposited by
an investor with his or her broker. Margins minimize
the possibility of a loss through a default on a contract
Example: An investor takes a long position in 2 December gold futures
contracts on June 5
– contract size is 100 oz.
– futures price is US$1250 per ounce
– initial margin requirement is US$6,000/contract (US$12,000 in total)
– maintenance margin is US$4,500/contract (US$9,000 in total)

Day Trade Settle Daily Cumul. Margin Margin

Price ($) Price ($) Gain ($) Gain ($) Balance ($) Call ($)
1 1,250.00 12,000
1 1,241.00 −1,800 − 1,800 10,200
2 1,238.30 −540 −2,340 9,660
….. ….. ….. ….. ……
6 1,236.20 −780 −2,760 9,240
7 1,229.90 −1,260 −4,020 7,980 4,020
8 1,230.80 180 −3,840 12,180
….. ….. ….. ….. ……
16 1,226.90 780 −4,620 15,180
 Valuation of Financial Futures
n The price of a financial futures contract generally reflects
the expected price of the underlying security as of the
settlement date
¨ As the market price of the financial asset changes, so will the
value of the contract
¨ Factors that influence the expected price of the asset influence
the futures’ price:
n The current price of the asset
n Economic or market conditions
n Impact of the opportunity cost
¨ Investors who buy stock index futures instead of the stock index
do not receive any dividends
¨ Investors who buy stock index futures put up a much smaller
investment
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Explaining Price Movements of
Bond Futures Contracts
n Participants in the Treasury bond futures market
closely monitor the same economic indicators
monitored by participants in the Treasury bond market:
¨ Employment
¨ GDP
¨ Retail sales
¨ Industrial production
¨ Consumer confidence
¨ Inflation indicators
¨ Indicators that reflect the amount of long-term financing

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 Speculating with Interest Rate Futures

n Involves trading T-bill futures

n The position taken depends on interest rate expectations
¨ If interest rates are expected to decline, purchase T-bill futures
¨ If interest rates are expected to increase, sell T-bill futures
n The maximum possible loss when purchasing futures is
the amount to be paid for the securities

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EXAMPLE

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Speculating with Interest Rate Futures
(cont’d)
Payoff from Purchasing Futures Payoff from Selling Futures

0 0
MV of Futures MV of Futures
at Settlement at Settlement

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Speculating on Increasing Interest Rates
An investor anticipates that interest rates are going to
decrease. Consequently, she purchases a T-bill futures
contract for 94.20 in February. On the March settlement
date, the T-bill futures contract has a price of 94.70.
What is the investor’s nominal profit from this strategy?
Profit = $947,000 - $942,000 = $5,000

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Speculating on Decreasing Interest Rates

An investor anticipates that interest rates are going to increase.

Consequently, she sells a T-bill futures contract for 94.20 in
February. On the March settlement date, the T-bill futures
contract has a price of 93.50. What is the investor’s nominal
profit from this strategy?
Profit = $942,000 - $935,000 = $7,000

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EXAMPLE

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Closing Out the Futures Position
n Rather than making or accepting delivery, most buyers
and sellers take offsetting positions to close out the
futures contract
¨ e.g., speculators who purchased T-bond futures contracts would
sell similar futures contracts by the settlement date
n If the futures price has risen over the holding period, speculators
who purchased interest rate futures will realize a positive gain
¨ Only about 2 percent of all futures contracts actually involve
delivery

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 Closing Out the Futures Position
A speculator purchased a futures contract on T-bonds at a
price of 90–12. Two months later, the speculator sells the
same futures contract in order to close out the position. At
that time, the futures contract specifies 93–14 of the par
value as the price. What is the nominal profit from this
futures transaction?
Profit = $93,437.50 - $90,375.00 = $3,062.50

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 Hedging with Interest Rate Futures

n The difference between a financial institution’s

volume of rate-sensitive assets and rate-sensitive
liabilities represents its exposure to interest rate risk
¨ In the long run, the institution could restructure its assets
or liabilities
¨ In the short run, the institution could use financial futures
to hedge its exposure to interest rate movements

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 Hedging with Interest Rate Futures
(cont’d)
n Using interest rate futures to create a short hedge
¨ Ifan institution has more rate-sensitive liabilities than
assets, it will be adversely affected by rising interest rates
n The institution could sell futures on securities with similar
characteristics than its assets
n “Short” position in future to hedge “long” position (in its own
assets)
n If interest rates rise, the loss on the rate-sensitive assets will be
offset by the gain on the short futures position

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Hedging with Interest Rate Futures
n Using interest rate futures to create a short hedge
(cont’d)
¨ Trade-off from using a short hedge
n Interest rate futures can hedge against both adverse and
favorable events
n The probability distribution of returns is narrower with hedging
than without hedging
n Institutions that frequently use interest rate futures may be able
to reduce the variability of their earnings over time

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 Hedging with Interest Rate Futures
n Using interest rate futures to create a short hedge
(cont’d)
¨ Cross-hedging is the use of a futures contract on one financial
instrument to hedge a position in a different financial instrument
n The effectiveness depends on the degree of correlation between the
market values of the two financial instruments
n e.g., a short position in Treasury bond futures to hedge interest rate
risk of a portfolio of corporate bonds
n Even with a high correlation, the value of the futures contract may
change by a higher or lower percentage than the portfolio’s market
value

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 Hedging with Interest Rate Futures
n Using interest rate futures to create a long
hedge
¨ If an institution has more rate-sensitive assets than
liabilities, it will be adversely affected by declining
interest rates
n The institution could purchase T-bill futures to lock in the
price at a specified future date
n If interest rates decline, any reduction in the bank’s earnings
will be offset by the gain on the short futures position

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Hedging with Interest Rate Futures
(cont’d)
n Hedging net exposure
¨ Net exposure reflects the difference between asset
and liability positions
¨ e.g., a bank has both long-term fixed-rate liabilities
and long-term assets
n If interest rates rise, the value of assets will decline, but the
bank benefits from the fixed rate of long-term liabilities

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 Risk of Trading Futures Contracts
n Market risk refers to fluctuations in the value of the instrument as a
result of market conditions
n Basis risk is the risk that the position being hedged is not affected in
the same manner as the instrument underlying the futures contract
n Liquidity risk refers to potential price distortions due to a lack of
liquidity
n Credit risk is the risk that a loss will occur because a counterparty
defaults on the contract
n Prepayment risk refers to the possibility that the assets to be hedged
may be prepaid earlier than their designated maturity
n Operational risk is the risk of losses as a result of inadequate
management or controls

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 Institutional Use of Futures Markets
Type of Financial Participation in Futures Markets
Institution
Commercial banks ØTake positions in futures contracts to hedge against interest rate
risk
Savings institutions ØTake positions in futures contracts to hedge against interest rate
risk
Securities firms ØExecute futures transactions for individuals and firms
ØTake positions in futures contracts to hedge their own portfolios
against stock market or interest rate movements
Mutual funds ØTake positions in futures contracts to speculate on future stock
market or interest rate movements
ØTake position in futures contracts to hedge their portfolios against
stock market or interest rate movements
Pension funds ØTake positions in futures contracts to hedge their portfolios against
stock market or interest rate movements
Insurance companies ØTake positions in futures contracts to hedge their portfolios against
stock market or interest rate movements
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 Globalization of Futures Markets (self – reading)
n Non-U.S. participation in U.S. futures contracts
¨ U.S. futures are commonly traded by non-U.S. financial institutions
that maintain holdings of U.S. securities
¨ The CBOT has expanded trading hours to cover various time zones
n Foreign stock index futures
¨ Foreign stock index futures have been created to speculate on or
hedge against potential movements in foreign stock markets
¨ Futures exchange have been established in Ireland, France, Spain,
and Italy
¨ Financial futures on debt instruments are offered by the London
International Financial Futures Exchange (LIFFE), the Singapore
International Monetary Exchange (SEMEX), and Sydney Futures
Exchange (SFE)
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 Globalization of Futures Markets (self – reading)
n Currency futures contracts
¨A currency futures contract is a standardized
agreement to deliver or receive a specified amount of a
specified foreign currency at a specified price (exchange
rate) and date
¨ Settlement months are March, June, September, and
December
¨ Currency futures are used by companies to hedge
foreign payables or receivables

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 Lecture example
Using the following data, show how three-year Treasury bond futures
contracts can be used to hedge the interest-rate risk that the business
currently faces. Show the timing of all transactions and cash flows
(ignore transaction costs and margin requirements).

It is noted that the Treasury bond futures contract is based on a 6% per annum
coupon rate with a face value of $100,000 and paying half-yearly coupons,
whereas the corporate bond has a coupon rate of 6.5% per annum and pays
interests semi-annually.

Today’s data:
(i) current corporate bond yield 7.5% per annum
(ii) three-year Treasury bond futures contract 93.000
Data in six months:
(iii) corporate bond yield per annum 7.25%
(iv) three-year Treasury bond futures contract 92.75

Also calculate the profit/ loss in physical market and futures market and explain
why the profit / loss in the futures market does not perfectly offset the loss/
profit in the physical market (assuming 365 days a year) 40
Homework
n Lecture example
n QA: 4,5,6
n Problems: 2,3,5,6,7

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