FIN650 FuturesContracts Week 1 Part 1

FIN 650: Week 1
Derivatives and non-Financial

Corporations
Contracts and Markets
Margin
Forwards vs. Futures
Futures Valuation
Hedging
Administrative Issues for Corporations

Seven Key Provisions of FAS 133 & IAS 39
Hedge accounting refers to the

standards for recording the changes
in value of both the derivative and
the hedged position.
1. Statements must recognize all
derivatives
2. Entries for derivatives must be at fair
value. Includes employee stock
options, warrants, convertible bonds
(How ?)
Continued
Seven Key Provisions of FAS 133 & IAS

39, cont.
3. Changes in market value of

derivatives must be recognized in
net income, except when they are
part of a designated hedge
then two choices:
1. the firm may record the change in
net income (as above), or
2. in the equity section of the
balance sheet as part of other
comprehensive income
3
Continued
4.For
hedged
assetofcarried
atIAS
SevenaKey
Provisions
FAS 133 &
cost:
39, cont.
with value of the derivative
hedge =>
carrying amount of the hedged
item
5.If the derivative does not fully
hedge the
asset in a designated hedge,
then:
Continued
portion not hedged must
be
4
Seven Key Provisions of FAS 133 &

IAS 39, cont.
6. Derivatives can serve as a tool:

Cash flow hedge
Fair value hedge
Foreign currency hedge
7. Embedded derivatives in
assets like convertible bonds
must be separated and
accounted for as if they were
standalone transactions
1.Cash flow hedges lower the

Three
Basic Types
of Hedges
fluctuations
of cash
inflows/outflows
Examples: hedge a floatingrate bond (an asset) or a
floating-rate obligation.
2.Fair value hedges focus on

market value and can apply to
assets, liabilities, and firm
commitments
Examples: inventories, a fixedrate obligation, fixed-rate bonds
Continued
(asset) not classified as held-to-
Cash Flow vs. Fair Value

Cash flow vs. fair value:
The item being hedged
determines the classification
e.g., a swap can serve as a cash
flow hedge for variable-rate debt
OR
It can be a fair value hedge for a
fixed-rate mortgage receivable
Continued
Three Basic Types of Hedges,

cont.
3.Foreign currency hedges

apply to the net investment in
a foreign operation
Can apply to entire
enterprise and not just to
specific positions
May be fair value or cash
flow hedges
8
Example: Disneys Risk Management Policy
Disney provides stated policies and procedures

concerning risk management strategies in its
annual report
The company tries to manage exposure to
interest rates, foreign currency, and the fair
market value of certain investments
Interest rate swaps are used to manage
interest rate exposure
Options and forwards are used to manage
foreign exchange risk in both assets and
anticipated revenues
The company uses a VaR (Value at Risk)
model to identify the maximum 1-day loss in
financial instruments
23-9
VaR: Value at Risk

VaR: The maximum loss that can be
expected a given percent of time.
Example: a $3,000,000; 99%, oneday VaR means that
the portfolio will lose at most (or
have a profit) $3,000,000 on 99 out
of 100 days.
OR, that one out of 100 days, the
portfolio will lose more than
$3,000,000.
VaR: estimating
The Delta-Normal method is popular
but assumes normal returns:
VaR = |( Z*)*(Value of Portfolio)|
If the expected return is = 10%
And the standard deviation is = 20%
For a $100,000,000 portfolio, the 95%
VaR is
VaR = |(0.1
1.645*0.2)*($100,000,000)|
VaR = $22,900,000
VaR: managing risk

The parameters = 10% and = 20%
correspond to a well-diversified stock
portfolio with BETA = 1 (over a one-year
horizon).
To lower VaR, the manager can lower .
Example: For a $100,000,000; the current
VaR is $22,990,000 but the Target VaR =
$20,000,000.
The manager can lower the VaR by taking a
short position in Futures on the S&P 500.
VaR: managing risk (cont.)

The parameters = 10% and = 20%
correspond to a well-diversified stock
portfolio with BETA = 1 (over a one-year
horizon).
Target VaR = $20,000,000
Target BETA? Solve:
$20,000,000 = $22,900,000*BETA
BETA = 0.8734
Short futures contracts !
How many ? Answered soon.
Futures Contracts:
issues and properties
Types
Exchanges
Terms
Margin
Forwards vs Futures
Valuation
Arbitrage
Backwardation and Contango
Adjusting Beta and Duration
Types of Futures and Related Assets
Agricultural Commodity Futures

Stock Indices Futures
Natural Resources Futures
Miscellaneous Commodities Futures
Foreign Currency Futures (Euro , , etc.)
T-Bills & Euro$s (the most active in US)
Futures
T-Notes & T-Bonds Futures
Index Futures (i.e., Equities Futures)
Managed Futures: Futures Funds (Commodity
Funds), Private Pools, Specialized Contract
Hedge Funds
Option on Futures
Forwards Used Most in Currency Hedging

3 Most Actively Traded Currency Futures
1. Euro with size of 125,000

2. British Pound with size of 62,500
3. Japanese Yen with size of 12,500,000
In US, Futures Prices Are Stated in $.
Example: $.8310 for is
12,500,000x$.008310/
=$103,875/Contract
Exchanges for Different Types

Chicago Board of Trade (CBOT)
Grains, Treasury bond futures
Chicago Mercantile Exchange
(CME)
Foreign currencies, Stock Index
futures, livestock futures,
Eurodollar futures
New York Mercantile Exchange
(NYMEX)
Crude oil, gasoline, heating oil
futures
Contract Terms:
1. Size
2. Grade, Quotation Unit
3. Delivery Terms: Delivery date(s),
Delivery Procedure, Expiration
Months, Final Trading Day, First
Delivery day
4. Minimum Price Change (e.g., 1/32
of 1 %,
0.0003125x$100,000 = $31.25 for TBond Futures)
5. Daily Price Limits & Trading Halts
EXAMPLE OF DETAILS
T-Bond Futures: Based on 8% Coupon & 15 Yrs' Maturity
T-Bond (Face Value $100,000)
Quoted in Dollar & 1/32 of par value of $100.

Ex. 111-17 is 111 17/32 = 111.53125,
or $111,531.25 (Face Value $100,000)
Expiration: March, June, Sept, Dec.
Last trading Day: the Business Day Prior to

the Last seven days of the expiration month.
The First Delivery Day = The First Business
Day of the Month
T-Notes Futures: Same As T-Bond Except the
maturity w/2 , 5 and 10 years T-Notes
Margin:
A: Initial Margin = m + 3d (m = the average of
the daily absolute changes in the dollar value
of a futures contract, d = the standard
deviation, measured over some time period in
the recent past).
Initial margin is used to cover all likely
changes in the value of a futures contract.
B: Maintenance Margin:
Equity position must be > Maintenance
margin or get a margin call must deposit
new $ (i.e., variation margin) up to Initial
Margin before the market opens on the next
Margin:
A:Initial Margin = m + 3d
Six days of value: 100, 104, 102, 96, 100, 104
Absolute value of changes: 4, 2, 6, 4, 4 (approx. %)
Average = 4%
Standard deviation = 1.414%
Margin = 4% + 4.243% = 8.243% of face value
If the contract is for 1000 units
If F = $100, the contract price is $100,000
=> $8,243 Margin
If, the price falls to approximately F = $95.88, this
would lead to a margin call for the long position.
Marking to Market
f0 =100, f1 = 102, f2= 101, f4= 98
In Long
Margin
Account
f0 =100
+2
f1 = 102
-1
-3
f4= 98
f2 = 101
At t=4,
Short Futures Position can close and make
2 (x$1000)
Margin Changes Example

F0 = 100
1000 unit contract. Margin is 8%
F
Margin Long
Margin Short
100
$8000
$8000
102
$10000
$6000
101
$9000
$7000
98
$6000
$10000
95.5*
$3500
$12500
*The minimum margin is 4% of $95500 or $3820

> $3500
Thus, the Long will have to add funds
Margin Call
If the price were to fall to 95.5, then
the long margin would only be $8000
- $4500 = $3500
If 8% is still the margin requirement,
then at that point, the required
margin is
$95.5*1000*0.08 = $7640
The maintenance margin is $3820 >
$3500
Spot, Forward, and Futures Contracts

A spot contract is an agreement (at
time 0) when the seller agrees to
deliver an asset and the buyer agrees
to pay for the asset immediately
(now)
A forward contract is an agreement
(at time 0) between a buyer and a
seller that an asset will be exchanged
for cash at some later date (at time
T) at a price agreed upon now
A futures contract is similar to a
Forward and Futures Markets

Futures and Forward contracts are
both agreements to buy/sell some
(financial) asset at a future date at
a price negotiated today
Despite their similarities there are
subtle but important differences
between the two types of contracts
Forward vs. Futures

Contracts
Forward Contracts
Futures Contracts
Delivery likely
Product may or may
not be standardized
Bilateral transaction
Generally over the
phone
Self-regulated
Margin and mark-tomarket optional (the
counterparties agree)
Offset likely
Standardized
product
Intermediary
involved
Auction setting
Regulated by
agencies
Mandatory margin
and mark-to-
Pros
Pros and Cons of Forward

Contracts
Can be as flexible as the two parties want them

to be (for example size and margin
requirement).
Anonymous (Private)
Cons
Difficulty in finding a counterparty to make the
contract with.
Lack of market liquidity ease of carrying out
financial transactions
Subject to default risk

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FIN 650: Week 1

Derivatives and non-Financial

Administrative Issues for Corporations

Hedge accounting refers to the

Seven Key Provisions of FAS 133 & IAS

3. Changes in market value of

Seven Key Provisions of FAS 133 &

6. Derivatives can serve as a tool:

1.Cash flow hedges lower the

2.Fair value hedges focus on

Cash Flow vs. Fair Value

Three Basic Types of Hedges,

3.Foreign currency hedges

Example: Disneys Risk Management Policy

Disney provides stated policies and procedures

VaR: Value at Risk

VaR: managing risk

VaR: managing risk (cont.)

Types of Futures and Related Assets

Agricultural Commodity Futures

Forwards Used Most in Currency Hedging

1. Euro with size of 125,000

Exchanges for Different Types

Quoted in Dollar & 1/32 of par value of $100.

Last trading Day: the Business Day Prior to

Margin Changes Example

*The minimum margin is 4% of $95500 or $3820

Spot, Forward, and Futures Contracts

Forward and Futures Markets

Forward vs. Futures

Pros and Cons of Forward

Can be as flexible as the two parties want them

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