Future markets and contracts

Future Markets and Contracts

Presented by

Amber Fatima

In the financial marketplace some instruments are regarded as fundamentals, while others are regarded as

derivatives.

Financial Marketplace

Derivatives Fundamentals

Simply another way to catagorize the diversity in the FM*. Futures

Forwards

Options

Swaps

Stocks Bonds

LOS 69.a. : Describe the characteristics of future contracts, and distinguish between future contracts and forward contracts

An agreement between a buyer and a seller to receive or deliver a product on a future date at a price

they have negotiated TODAY.

What Is A Futures Contract?

Futures vs. ForwardsForward•Private contracts between two parties•Not standardize•Usually are one specific deliver date settle

at end of contract•Delivery or final cash settlement takes

place•Some credit risk exist

Future•Traded on an exchange•Standardize contract•Range of delivery dates•Settled daily ( marked to market)•Contract is usually close out prior to

maturity •No credit risk•Clearing house of the exchange guarantee

payments to both parties

LOS 69.a.

Contract standardized with respect to:

Delivery Period (timing)

Contract Size (quantity) Quality of the

Product The manner of delivery

Exchange set the Minimum price

fluctuation ( Tick Size)

Exchange also set the trading timings

The only negotiable terms are price and the

number of contracts involved

in each trade.

LOS 69.a.

Characteristics of Futures Contracts

Transaction will not be completed until some agreed-upon date in the future

Delivery date and quantity are all set when the financial future is created

Seller has legally binding obligation to make delivery on specified date

Buyer/holder has legally binding obligation to take delivery on specified date

Futures may be held until delivery date or traded on futures market

All trading is done on a margin basis

The futures price is simply what a buyer is willing to pay and a seller is willing to accept for a product. The exchange (CME, NYBT, CBOT) itself does not set prices.

Once you’ve established a “long” (buy) or “short” (sell) position in the futures market, the value of your position (gain or loss) changes each time prices change.

LOS 69.a.

LOS 69.a.

• Hedger are in the position where they face risk associated with the price of an asset . They use derivative to reduce / eliminate risk

• Example : Farmers will sell futures to guarantee the price at which they will be able to sell their wheat

Using Future contract by

Hedger

• Speculator wish to bet on future movement in the price of an asset

• They use derivative to get extra leverage – high return

Using Future Contract by Speculators

LOS 69.a.

Short Position• A Seller of a future contract has a

short position• Short has an obligation to sell at

contract price

Long Position

• A trader who contacts a broker and buys future is said to have a long position

• The long has contracted to buy the asset at the contract price at contract expiration

LOS 69.a.

Buying or Selling Futures

When one “buys” a futures contract, one agrees with the exchange to a daily settlement procedure that is only loosely analogous to buying the commodity. One must post initial margin with the futures commission merchant.

Usually, one has no intention of taking delivery of the commodity

Same as when one “sells” a futures contract, no intention of selling the commodity. Again, post margin.

LOS 69.a.

Clearing House

Each Exchange has a clearinghouse

Clearing house guarantees that traders in the future market will honor their obligations

It acts as the buyer to every seller and the seller to every buyer

Traders can easily reverse their positions from long to short at future date

LOS 69.a. : Describe the characteristics of future contracts, and distinguish between

future contracts and forward contracts

Margin in Securities Markets• Margin on a stock/bond is a

percentage of the market value of the asset

• 50% of stock purchase by borrowed amount, interest charged on the borrowed amount is margin loan

Margin in Future Markets• Margin is a performance

guarantee.• It’s the money deposited by

both the long and the short• No loan involved , no

interest charges

LOS 69.b.

Initial margin: The amount deposited in a future account . It equals about one day’s price settlement

Maintenance margin: The amount of margin that must be maintained in a future account

• If balance falls below maintenance margin , a margin call take place and fund must be added back to the amount of initial margin

• If funds not added , position is liquid

Variation margin – is the funds that must be deposited into the account to bring it back to the initial margin amount

• Usually settled in cash with the broker each morning

LOS 69.b.

Previous day settlement Price

= $1.04

• Daily Price limit ( up / down )= $ 0.02

If today traders wishes to trade

at $1.07

• No trade will take place• Settlement Price will be reported as

$1.06 ( Mark to Market), • the contract will be LIMIT MOVE , PRICE

=> LIMIT UP

If Today traders wishes to trade

below $1.02

• No trade will take place• Settlement Price will be reported as

$1.02( Mark to Market ) ,• the contract will be LIMIT MOVE , PRICE

=> LIMIT DOWN

Locked Limit

LOS 69.c. : Describe price limits and the process of marking to market , and compute and interpret the margin balance ,

given the previous day’s balance and the change in the future price

Five July Wheat Contracts

Each contract covers 5,000

bushels

Initial Margin per Contract = $ 150 => so for 5 contracts TOTAL Initial Margin = 5

* 150 = $ 750

Maintenance Margin per

Contract = $ 100 => so for 5

contracts = 5 * 100 => $500

Price change of a cent $0.01 per bushel

changes a contract value by = 5000 * 0.01 = $50

So each 5 contracts = 5 *

$50 = $250

LOS 69.c.

Day Required Deposit

Price / Bushel Daily Change Gain / Loss Balance

0 ( Purchase) $750 $2.00 0 0 $750

1 0 $1.98 -$0.02 -$500 $250

2 $500 $1.99 +0.01 +250 $1000

3 0 $1.98 -0.01 -$250 $750

Initial Margin deposit for each contract = $ 150

For 5 contracts = 5 * $150 = $750

Since Maintenance Margin required = $500

Current Deposit ($750) > Maintenance Margin , so no required further deposit

Current Deposit $250 less Min. Maintenance Margin , so required $500

1 cent down reduces Margin balance by $2503rd day balance = $1000+ 0 -$250 = $750

LOS 69.c.

LOS 69.d. : Describe how a future contract can be terminated at or prior to expiration by a close-out ( i.e. , offset ) , a delivery , an

equivalent cash settlement , or an exchange –for-physicals.

4 ways to terminate a future contract

Delivery :Short by

delivering the

goods ,long by paying price to

short

Cash Settlement

PriceReversing Position

Exchange for

physicals

Short term future contracts

•Eurodollar•U.S. Treasury Bills

Intermediate Future

Contracts•U.S. Treasury Notes

Long Term Future Contract

•U.S. Treasury Bonds

LOS 69.e. Describe the characteristics of the following types of future contracts ; Eurodollar , Treasury bonds , stock index and

currecny

21

U.S. Treasury bills Future Contracts:

• Are sold at a discount from par value• Are sold with 91-day and 182-day maturities at a weekly auction• Settle in cash• Are calculated following a standard convention

T-bill price = Face value - Discount amount

Days to maturityDiscount amount = Face value ( ) Ask discount360

Standard convention:

LOS 69.e.

U.S. Treasury bills Future Contracts:

•Example•A 90-day (13 weeks) T-bill future contract , face value $1 Million. Price quote as $98.52•Annualized discount %= (100 - 98.52 )/100 = 0.0148 or 1.48%•Actual Discount % = 0.0148 * (90 / 360 ) = 0.0037•Discount Amount = Face Value * 0.0037 = $3,700•Delivery Price = Face Value – Discount Amount•= $1000,000 - $3,700 = $996,300

LOS 69.e.

U.S. Treasury bills / Eurodollar Tick Size

•T-Bills / Eurodollar of 90 days of $1 Million Future Contract•Each change in Price of 1 cent ( $0.01) of a T-Bills / Eurodollar ,discount of 0.01 %•0.01 %*( 90/360) * $ 1 Million = $25 •A price change 1 cent in T-bill / Eurodollar represent change of $25 in contract of $1 Million •e.g. Price falls from $98.52 to $98.50 , $50 loss per contract

LOS 69.e.

T-notes have a life of less than ten year

• T-bonds are callable fifteen years after they are issued

U.S. Treasury bond futures:

• Pay semiannual interest• Have a maturity of up to 30 years• Trade readily in the capital markets

U.S. Treasury bonds differ from U.S. Treasury notes:• Call for the delivery of $100,000 face value of U.S. T-bonds• With a minimum of fifteen years until maturity (fifteen years of call

protection for callable bonds)• Bonds that meet these criteria are deliverable bonds

A conversion factor is used to standardize deliverable bonds:

• The conversion is to bonds yielding 6 percent• Published by the Chicago Board of Trade• Is used to determine the invoice price

LOS 69.e.

Position day is the day the bondholder notifies the

clearinghouse of an intent to delivery bonds against a futures

position

At any given time, several bonds may be eligible for delivery• Only one bond is cheapest to

delivery• Normally the eligible bond with

the longest duration• The bond with the lowest ratio

of the bond’s market price to the conversion factor is the cheapest to deliver

LOS 69.e. : Describe the characteristics of the following types of futures contracts : Eurodollar ,

Treasury bond , stock index, and currency

Suppose $1000 Treasury bond with 8% coupon, currently trading at 92, 6% short term rate

If futures contract selling at 910:Now:Borrow funds +920Buy bond -920Sell Treasury futures 0Net cash flow 0

One year later:Receive coupon +80Deliver bond at contract price +910Pay off loan -920Pay off loan interest _55Net cash flow +15

Which bond to buy? "Cheapest to deliver"



If futures contract selling at 880:

Now:Short bond in cash market +920Invest funds at 6% -920Buy bond futures 0Net Cash Flow 0

One year later:Receive loan principal +920Receive loan interest +55Pay coupon on shorted bond -80Buy bond at contracted price -880Deliver on bond ___ _Net Cash Flow 15



Profit and loss of a futures transaction

A march 2005 treasury bond futures contract traded on CBT on Jan. 10, 2005 is 112 11/32 (or 112.34375) percent of the face value of the T-bond. The contract size is $100,000. So the position can be taken with a price of $112,343.75.

The subsequent movement of the T-bond futures price falls to 111-16 (111.5%), the long position incurs a loss of (111.5-112.34375)%*100,000= -$843.75.

LOS 69.e.

LOS 69.e

Currencies Standard Contract Sizes:

• 1) British pound [ contract size = 62,500 ]• 2) Euro [ contract size = 125,000 Euro]• 3) Canadian dollar• 4) Japanese yen• 5) Deutsche mark• 6) Australian dollar• 7) Swiss franc

Currency Future :Long and Short Exposures

A person that is, for example, long the pound, has pound denominated assets that exceed in value their pound denominated liabilities.

A person that is short the pound, has pound denominated liabilities that exceed in value their pound denominated assets.

LOS 69.e

Hedging With a Currency Future

To hedge a foreign exchange exposure, the customer assumes a position in the opposite direction of the exposure.

For example, if the customer is long the pound, they would short the futures market.

A customer that is long in the futures market is betting on an increase in the value of the currency, whereas with a short position they are betting on a decrease in the value of the currency.

LOS 69.e

Example LOS 69.e

The firm is long the peso,

so to hedge the exposure they will go short in the

futures market.

The face amount of each peso

future contract is MP500,000, so the firm will go

short 8 contracts.

If the peso depreciates, the

dollar value of the division’s profits

falls, but the future account generates

profits, at least partially offsetting

the loss. The opposite holds for an appreciation of

the peso.

LOS 69.e

Change spot value

Change in futures price

Gain

Loss

Underlying Long Position

Futures Position

This diagram illustrates the effect of a change in the value of the peso.

An increase in the value of the peso increases the dollar value of the underlying long position and decreases the value of the futures position.

A decrease in the value of the peso decreases the value of the underlying position and increases the value of the futures position.



On the 25th, the spot rate opens at 0.10660 ($/MP) while the price on a MP future opens at 0.10310.

The market closes at 0.10635 and 0.10258

respectively.

The loss on the underlying position is:•(0.10635-0.10660)MP4 mil. = -$1,000

The gain on the futures position is:•(0.10310-0.10258)8MP500,000=$2,080

Gain and Loss on Underlying and Futures Position Day 1 LOS 69.e.

Change spot value


Gain

Loss

Underlying Long PositionMP4 million

Futures PositionMP500,000 x 8

-0.00025

-0.00052$1,000

$2,080

Gain and Loss on Underlying and Futures PositionDay 1

On the 28th, the spot rate moves to 0.10670

($/MP) and the price on a MP future to 0.10285.

The gain on the underlying position is:• (0.10670-

0.10635)MP4 mil. = $1,400

The loss on the futures position is:• (0.10258-

0.10285)8MP500,000=-$1,080


Change spot value


Gain

Loss



$1,080

$1,400

0.00035

0.00032


On the 29th, the spot rate moves to 0.10680 ($/MP)

and the price on a MP future to 0.10290.

The gain on the underlying position is:• (0.10680-0.10670)MP4

mil. = $400

The loss on the futures position is:• (0.10285-

0.10290)8MP500,000=-$200


Change spot value


Gain

Loss



$200

$400

0.00005

0.0001


For the three days considered, the underlying

position gained $800 in value and the futures

contracts yielded $800.

The hedge was not perfect as the daily losses on the futures were

less than the gains on the underlying position (day 2 and 3), and the daily gains on the futures

exceeded the losses on the underlying position (day 1).

In this example, the imperfect hedge yielded

additional gains.

LOS 69.e.

THANK YOU

Future markets and contracts

Education

Transcript of Future markets and contracts