Introduction Fundamentals of futures

Development of futures contracts Futures product/contract characteristics Types of trades Participation in the futures contracts FX Futures trade life cycle Comparison with forward contracts Benefits of futures contracts / usage Closing out a position

Futures Market – Key players The players Hedging strategies Risk reduction Need to reduce credit risk Hedging versus speculating

Conclusion

• Course Overview

• Course objectives

• Asset Classes

• FX Instruments

• Futures

Development of Futures Contracts

– Have been used for centuries to facilitate future delivery of commodities

– Legally bind a party to buy or sell a specific quantity of a well defined asset at a well defined time in future

– Delivery of asset can either be specified for a particular date or within a particular short period of time

– Now, application of forward contracts has expanded to include financial instruments

Collateralized forward contracts Traditional forward contracts between trusted counter parties Each accepted the risk that the other might

default With counterparties collateralized, forward

contracts were used to mitigate credit risk One party would place some liquid asset with

the other to guarantee performance Often seller could use collateral to obtain bank

financing to cover the cost of commodity sold

Dual collateralized forward contracts Eventually the question of performance was

raised on both sides Of course, it made little sense for two parties

to hand each other the same amount of collateral

Since default on the agreement would involve a loss of collateral placed by non defaulting party

Solution was to place the collateral with an intermediary, creating dual collateralized contracts

• Amount of parties collateral has to cover both credit risk and financial risk (price risk) of non performance

• With long term agreements, this price risk could be quite large and the collateral equally as large

• To reduce amount of initial collateral deposit, long term dual collateralized agreements

called for periodic payments to cover price changes during agreement’s term

• Suppose a three year agreement states that if a price movement occurs during any month, the adversely affected party will be required to make an additional collateral contribution.

• In this case, the initial collateral only has to cover the price risk for one month, not the entire three years

• This process of comparing forward contract rate to current market conditions to determine accrued profit or loss is called marking to market

• The amount of collateral which is periodically modified according to

MTM process is called margin

• With more frequent marked to market margining, less initial collateral is required

• To reduce credit risk to a minimum, daily margining (or even more frequently) has become a common practice

• In addition, if the mark-to-market margin is always in cash, and passed from the loser to the gainer, then performance risk is very low.

• If the third party holding the initial collateral adds a financial guarantee, it effectively removes the credit risk of the counterparty and replaces it with a well-collateralized credit risk of an intermediary

• Offsetting transactions– One can further reduce the amount of initial

collateral by offsetting the price risk with two different forward transactions.

– Properly structured, these agreements allow the first party to reduce its collateral with an intermediary whenever the price risk is reduced with two positions that offset each other.

• Standard agreements– To increase the likelihood that two agreements

have the same offsetting price risk, standard agreements are written with the help of an intermediary.

– In these agreements, the only negotiable issue is the price; all other terms are defined.

• From the perspective of an intermediary holding the collateral, it doesn't matter who the counterparty is.

• Thus, offsetting positions held by any one party are netted and removed from the books.

• If an intermediary is intimately involved in the writing of the agreements used, and then guarantees financial performance, it might just as well become the offsetting counterparty to every transaction.

• For example, if Party A agrees to buy at a price of 90 from Party B, then the intermediary can just as easily agree to buy at a price of 90 from Party B and sell at a price of 90 to Party A.

• A basic forward contract contains :– Description of the underlying asset– Delivery conditions (including

dates)– Price– Payment conditions– Conditions for endorsing to third

parties– Provision for handling exceptions– Quantity– Points of delivery– Settlement price determination– Margining process

• When forward contracts are written in a standardized manner with:– an initial collateralization;– mark-to-market margining;– a publicly-regulated third party as

counterparty in every matched trade,– allowing the netting of offsetting exposures, –  the result is called a futures contract.

• This third party is comprised of a futures exchange for rulemaking and trading, and a clearinghouse for settlement and administrative duties. The initial collateral is known as an initial margin deposit

Hedging

Arbitraging

Speculating

• A cash contract delivery is immediate in exchange for payment (according to normal delivery procedures). The date of the delivery and payment is often called the spot date.

•  A forward contract an agreed-upon delivery date in the future. Payment is at delivery, or the agreement establishes the parameters for determining a cash settlement on the future date.

•  A futures contract similar to a forward contract, except that it is standardized, adds mark-to-market margining to reduce credit risk, and is established through an organized exchange

Buyers and sellers of futures contracts have two alternatives available for closing out a position. The buyer can accept (or the seller can

deliver), the asset on the date specified in the contract, unless the contract is cash settled, in which case the final margin payment closes the position.

 The buyer and seller can offset their positions prior to delivery date

• Most futures contracts are offset before the delivery date; buyers seldom take possession of the asset — and sellers seldom deliver the asset.

• Buyers (holders of a long position) offset by selling an identical contract for the same delivery month. Holding a long position means they profit if the futures price of the underlying asset increases

• Sellers (holders of a short position) offset by buying an identical contract for the same delivery month. Holding a short position means they profit if the futures price of the underlying asset decreases.

• In other words, either the buyer or seller can offset a position with another transaction that is opposite (buyers sell and sellers buy) and equal (identical contract and amount).

 

FUTURES MARKETS

– The standardization of futures contract terms helps to increase the liquidity (volume of trading) in individual futures contracts because parties with similar, though different, positions choose the same futures contract.

– The strict margining process removes credit risk, which allows for greater participation in the futures market than in the traditional forward market.

– In addition to the large banks and multi-national corporations that use forward contracts, small companies and individuals that usually cannot use forward contracts can easily participate in the futures market.

• Profit opportunity with risk–  A trader who engages in speculation enters

into a transaction because it offers the opportunity for a large profit.

–  Speculators trade futures to gain leverage, which is the potential for profit without substantial capital commitment.

– For a margin deposit of 10%, an unanticipated 5% increase results in a return on capital of 50% (less transaction costs).

– Of course there is a possibility that futures prices may decline and cause a loss for the trader.

Play one market against another A trader who engages in arbitrage

attempts to profit by simultaneously purchasing and selling closely-related instruments in different markets.

Arbitragers play one market against another, looking for a product that is overvalued in one market relative to the other.

They buy where it is undervalued, sell where it is overvalued, and make a profit if the differential exceeds transaction and carrying costs (the cost of arbitrage). 

• Locals : Locals work on the floor of an exchange who engage in speculation & arbitrage for their own accounts, hoping to profit from the minute-by-minute flow of futures transactions

• Offsetting risk in current position– Hedging is the purchase or sale of financial

instruments with the objective of protecting overall results by offsetting the risk inherent in a current position.

– Hedging to lock-in a loss is advisable when changes in market conditions are likely to result in greater losses. 

– In commodities markets, hedgers anticipate the future need for a product, act to preset a favorable price, guarantee supply or demand, and protect themselves against possible losses.

– They buy or sell futures contracts that serve as substitutes for later positions in a physical market in order to reduce risk.

• Either make a profit or reduce risk•  Trading for Profit :  Speculators and

arbitragers–  Both speculators and arbitragers (including

locals) attempt to profit by seeking trading opportunities that offer large returns. However, each works in a different way:

–  The speculator assumes a large amount of risk for the possibility of equally large returns.

– The arbitrager looks for market inefficiencies to make a profit.

–  You can say that speculators help launch markets — and arbitragers make them more efficient. Both speculators and arbitragers add to the liquidity of the market.

• Trading to Reduce Risk : Hedgers– In contrast, hedgers seek to reduce risk

inherent in their business by locking in returns on investments, fixing costs, and guaranteeing the future supply of currencies and commodities required for their operations.

– Corporations usually trade in the futures market as hedgers.

– Now that we have examined the four types of traders and their motives, let's move to the hedging strategies traders use to reduce risk.

The only motivation behind hedging is the reduction of risk. Therefore, hedging requires knowledge about the asset to be delivered and the effect of economic forces on its future and cash markets.

– A Chief Financial Officer expects interest rates to drop, an effect that has not yet been anticipated by the market. He knows his organization will be receiving USD 10 million three months ahead, which he will invest in Treasury bonds. Since T-bond futures are quoted in USD 100,000 lots, he buys 100 T-bond futures in order to lock in today's futures interest rate.

• A Japanese exporter of robots will receive USD 1,000,000 in six months. She is worried that the U.S. dollar might fall in value against the Japanese yen. She buys Japanese yen futures contracts, agreeing to pay U.S. dollars in the future and receive yen in the future. This reduces the risk of the U.S. dollar falling in value and the yen rising in value.

• A corporate treasurer expects floating (variable) interest rates to rise. In order to hedge its floating-rate loan interest cost, the corporation sells Eurodollar futures (ED). As short-term interest rates rise, the price of the ED futures will fall, and the corporation will receive profit from the futures position. This profit will be used to offset the added interest cost on the loan.

Many corporations that are active in the futures markets look for underlying assets that imitate or mimic trends they either want to take advantage of or protect against. Mimicking can be:

direct, where the asset closely follows a trend, or

Inverse, where the asset moves in the opposite direction.

• Direct mimic : Stock market index futures are direct mimics of overall economic health. They are directly proportionate to the economic changes.

•  Inverse mimic : However, when the economy deteriorates, people tend to hoard gold which causes gold prices to rise. This is an inverse mimic of general economic trends because it is contrary to them.

Businesses engage in hedging activities because they:

•  Require specific quantities of certain assets

• Recognize that the spot and future prices of certain assets reflect economic realities

• Want to avoid risk

• If a party has no underlying (intrinsic) exposure, then establishing a position with the futures contract is definitely speculation. If a party has an underlying exposure and uses a futures position to reduce the business risk of that underlying exposure, then the process is called hedging.

• Selective hedging is actually speculating. Often, text refers to hedging an underlying exposure because the party expects the market conditions to change unfavorably. This selective hedging is actually speculating, since the hedge is only taken based upon the speculation that the yen will weaken.

• True hedging must be a consistent policy independent of expectations