INVESTMENTS:INVESTMENTS:Analysis and ManagementAnalysis and Management
Second Canadian EditionSecond Canadian Edition
W. Sean Cleary
Charles P. Jones
Chapter 20Chapter 20
FuturesFutures
• Describe the structure of futures markets.
• Outline how futures work and what types of investors participate in futures markets.
• Explain how financial futures are used.
Learning ObjectivesLearning Objectives
• Spot or cash market Price refers to item available for immediate
delivery• Forward market
Price refers to item available for delayed delivery• Futures market
Sets features (contract size, delivery date, and conditions) for delivery
Understanding Futures MarketsUnderstanding Futures Markets
• Futures market characteristics Centralized marketplace allows investors to trade
with each other Performance is guaranteed by a clearinghouse
• Valuable economic functions Hedgers shift price risk to speculators Price discovery conveys information
Understanding Futures MarketsUnderstanding Futures Markets
• Commodities – agricultural, metals, and energy related
• Financials – foreign currencies as well as debt and equity instruments
• Foreign futures markets Increased number shows the move toward
globalization
Understanding Futures MarketsUnderstanding Futures Markets
• An obligation to buy or sell a fixed amount of an asset on a specified future date at a price set today Trading means that a commitment has been
made between buyer and seller Position offset by making an opposite contract
in the same commodity
Futures ContractFutures Contract
• Where futures contracts are traded• Voluntary, nonprofit associations, typically
unincorporated• Organized marketplaces where established
rules govern conduct Financed by membership dues and fees for
services rendered
• Members trade for self or for others
Futures ExchangesFutures Exchanges
• A corporation separate from, but associated with, each exchange
• Exchange members must be members or pay a member for these services Buyers and sellers settle with clearing
corporation, not with each other
• Helps facilitate an orderly market• Keeps track of obligations
The Clearing CorporationThe Clearing Corporation
• Through open-outcry, seller and buyer agree to take or make delivery on a future date at a price agreed on today Short position (seller) commits a trader to
deliver an item at contract maturity Long position (buyer) commits a trader to
purchase an item at contract maturity
• Like options, futures trading is a zero-sum game
The Mechanics of TradingThe Mechanics of Trading
• Contracts can be settled in two ways: Delivery (less than 1% of transactions) Offset: liquidation of a prior position by an
offsetting transaction
• Each exchange establishes price fluctuation limits on contracts
• No restrictions on short selling• No assigned specialists
The Mechanics of TradingThe Mechanics of Trading
• Good faith deposit made by both buyer and seller to ensure completion of the contract Not an amount borrowed from broker
• Each clearing house sets its own requirements Brokerage houses can require higher margin
• Initial margin usually less than 10% of contract value
Futures MarginFutures Margin
• Margin calls occur when price goes against investor Must deposit more cash or close account Position marked-to-market daily Profit can be withdrawn
• Each contract has maintenance or variation margin level below which the investor’s net equity cannot drop
Futures MarginFutures Margin
• Hedgers At risk with a spot market asset and exposed
to unexpected price changes Buy or sell futures to offset the risk Used as a form of insurance Willing to forgo some profit in order to reduce
risk• Hedged return has smaller chance of low return
but also smaller chance of high return
Using Futures ContractsUsing Futures Contracts
• Short (sell) hedge Cash market inventory exposed to a fall in value Sell futures now to profit if the value of the
inventory falls• Long (buy) hedge
Anticipated purchase exposed to a rise in cost Buy futures now to profit if costs increase
HedgingHedging
• Basis: difference between cash price and futures price of hedged item Must be zero at contract maturity
• Basis risk: the risk of an unexpected change in basis Hedging reduces risk if basis risk less than
variability in price of hedged asset
• Risk cannot be entirely eliminated
Hedging RisksHedging Risks
• Speculators Buy or sell futures contracts in an attempt to
earn a return• No prior spot market position
Absorb excess demand or supply generated by hedgers
Assuming the risk of price fluctuations that hedgers wish to avoid
Speculation encouraged by leverage, ease of transacting, low costs
SpeculatingSpeculating
• Contracts on equity indexes, fixed income securities, and currencies
• Opportunity to fine-tune risk-return characteristics of portfolio
• At maturity, stock index futures settle in cash Difficult to manage delivery of all stocks in a
particular index
Financial FuturesFinancial Futures
• Interest rate futures If increase (decrease) in rates is expected, sell
(buy) interest rate futures• Increase (decrease) in interest rates will decrease
(increase) spot and futures prices Difficult to short bonds in spot market
Interest Rate FuturesInterest Rate Futures
• Selling futures contracts against diversified stock portfolio allows the transfer of systematic risk Diversification eliminates nonsystematic risk Hedging against overall market decline Offset value of stock portfolio because futures
prices are highly correlated with changes in value of stock portfolios
Hedging with Stock Index FuturesHedging with Stock Index Futures
• Index arbitrage: a version of program trading Exploitation of price difference between stock
index futures and the cash price of the underlying index
Arbitrageurs build hedged portfolio that earns low risk profits equaling the difference between the value of cash and futures positions
Program TradingProgram Trading
• Futures effective for speculating on movements in stock market because: Low transaction costs involved in establishing
futures position Stock index futures prices mirror the market
• Traders expecting the market to rise (fall) will buy (sell) index futures
Speculating with Stock- Index Speculating with Stock- Index FuturesFutures
• Futures contract spreads Both long and short positions at the same time in
different contracts Intramarket (calendar or time) spread
• Same contract, different maturities Intermarket (quality) spread
• Same maturities, different contracts
• Interested in relative price as opposed to absolute price changes
Speculating with Stock-Index Speculating with Stock-Index FuturesFutures
Appendix 20-A Future OptionsAppendix 20-A Future Options
• Put and call options are offered on both interest rate futures and stock-index futures
• Several options on futures contracts: On foreign exchange: pound, mark, Swiss franc, yen,
etc. On interest rate futures: US Treasury bills, notes and
bonds On stock-index futures: The S&P 500 Index, NYSE
Composite Index, and the Nikkei 225 Stock Average On commodities: Agricultural, oil, livestock, metals and
lumber
Appendix 20-A Futures OptionsAppendix 20-A Futures Options
• Key elements of a future option are the exercises price and the premium
• Future options contracts can serve some the same purposes as the futures contracts themselves
• A rise in interest rates is bearish, so the portfolio manager would either buy a put or sell a call
• Appeal of future options is the limited liability assumed by the purchaser
Appendix 20-BAppendix 20-BOther Derivative SecuritiesOther Derivative Securities
• Swap A cash settled forward agreement with a series of
predetermined payments• Interest rate swaps represent agreements to
exchange cash flows on an agreed upon formula; the notional or principal amount is not exchanged, either at initiation or maturity of the contract
• Foreign exchange swaps or currency swaps: the notional amount is exchanged at the beginning and end of the contract; not necessarily have to be fixed for floating
• Swaptions give the holder the right to enter into a swap agreement.
Appendix 20-BAppendix 20-BOther Derivative SecuritiesOther Derivative Securities
• Embedded Options Include features such as convertible, callable,
retractable, and extendible features associated with some debt or preferred share issues
Copyright © 2005 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (The Canadian Copyright Licensing Agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information contained herein.
CopyrightCopyright
Top Related