Chapter 13

Financial Futures Markets

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Background on financial futures Interpreting financial futures tables Valuation of financial futures Explaining price movements of bond futures contracts Speculating with interest rate futures Closing out the futures position

Chapter Outline (contd)

Hedging with interest rate futures Bond index futures Stock index futures Single stock futures Risk of trading futures contracts Regulation in the futures markets Institutional use of futures markets Globalization of futures markets

Background on Financial Futures

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 The exchanges clear, settle, and guarantee all transactions that occur on the exchange

Futures are traded on organized exchanges

Futures are regulated by the Commodity Futures Trading Commissions (CFTC)

Approves futures contracts and imposes regulations

Background on Financial Futures (contd)

Interest rate futures are on debt securities such as T-bills, T-notes, T-bonds, and Eurodollar CDs 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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Background on Financial Futures (contd)

Purpose of trading financial futures

Traded either to 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

Day traders attempt to capitalize on price movements during a single day Position traders maintain their futures positions for longer periods of time

Hedgers take positions to reduce their exposure to future movements in interest rates or stock prices

Background on Financial Futures (contd)

Electronic trading
The

Chicago Mercantile Exchange established GLOBEX that compliments its floor trading
Allows for around the clock and weekend trading

The

Chicago Board Options Exchange implemented a fully electronic futures exchange in 2004

Background on Financial Futures (contd)

Steps involved in trading futures

Members

of a futures exchange are either:

Commission brokers, who execute orders for their customers and are often employed by brokerage firms Floor traders (locals), who trade futures contracts for their own account

Many

types of futures contracts now trade over the counter

Are more personalized and can be tailored to the specific preferences of the parties involved

Background on Financial Futures (contd)

Steps involved in trading futures (contd)

Customers must establish margin deposits with their brokers

Initial margin is typically between 5 and 18 percent of a futures full value Customers may receive a margin call if the value moves in an unfavorable direction

A futures contract price is marked to market daily

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

Background on Financial Futures (contd)

Steps involved in trading futures (contd)

How

orders are executed

Brokerage firms communicate customers order to telephone stations located near the trading floor Floor brokers accommodate orders When two traders on the floor reach an agreement through open outcry, the information is transmitted to the customers Floor brokers receive transaction fees in the form of a bidask spread The futures exchange acts as a clearinghouse

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Interpreting Financial Futures Tables

The Wall Street Journal provides a comprehensive summary of trading activity on various financial futures contracts Example of Treasury bill futures quotations:
Discount

Open
Sept 2005 93.80

High
94.05

Low

Settle

Change
+.28

Settle
5.95

Change
.28

Open
2,519

93.80 94.05

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Characteristic of Futures Contract

Size Deliverable grade

Treasury Bond Futures

$100,000 face value Treasury bonds maturing at least 15 years from date of delivery is not callable; coupon rate is 8%

Treasury Note Futures

$100,000 face value Treasury notes maturing at least 6.5 years but not more than 10 years from the first day of the delivery month; coupon rate is 6%

Price quotation Minimum price fluctuation Daily trading limits

In points ($1,000) and thirty-seconds In points ($1,000) and thirtyof a point seconds of a point One thirty-second (1/32) of a point, or $31.25 per contract Three points ($3,000) per contract above or below the previous days settlement price March, June, September, December One thirty-second (1/32) of a point, or $31.25 per contract Three points ($3,000) per contract above or below the previous days settlement price March, June, September, December
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Settlement months

Valuation of Financial Futures

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:

The current price of the asset Economic or market conditions

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

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

Involves trading T-bill futures 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

The maximum possible loss when purchasing futures is the amount to be paid for the securities

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Speculating with Interest Rate Futures (contd)

Payoff from Purchasing Futures Payoff from Selling Futures

0 MV of Futures at Settlement

0 MV of Futures 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 investors 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 investors nominal profit from this strategy?

Profit $942,000 $935,000 $7,000

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Speculating with Interest Rate Futures (contd)

Impact of leverage
The

return is magnified substantially when considering the relatively small margin maintained by many investors

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Closing Out the Futures Position

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

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 9012. 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

The difference between a financial institutions volume of rate-sensitive assets and ratesensitive 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 (contd)

Using interest rate futures to create a short hedge

If

an institution has more rate-sensitive liabilities than assets, it will be adversely affected by rising interest rates

The institution could sell futures on securities with similar characteristics than its assets 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 (contd)

Using interest rate futures to create a short hedge (contd)

Tradeoff

from using a short hedge

Interest rate futures can hedge against both adverse and favorable events The probability distribution of returns is narrower with hedging than without hedging 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 (contd)

Using interest rate futures to create a short hedge (contd)

Cross-hedging is the use of a futures contract on one financial instrument to hedge a position in a different financial instrument

The effectiveness depends on the degree of correlation between the market values of the two financial instruments e.g., a short position in Treasury bond futures to hedge interest rate risk of a portfolio of corporate bonds Even with a high correlation, the value of the futures contract may change by a higher or lower percentage than the portfolios market value

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Hedging with Interest Rate Futures (contd)

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

The institution could purchase T-bill futures to lock in the price at a specified future date If interest rates decline, any reduction in the banks earnings will be offset by the gain on the short futures position

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Hedging with Interest Rate Futures (contd)

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

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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Bond Index Futures

A bond index futures contract allows for the buying an selling of a bond index for a specified price at a specified date The CBOT offers Municipal Bond Index (MBI) futures
Based

on the Bond Buyer Index of 40 actively traded general obligation and revenue bonds

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Stock Index Futures

A stock index futures contract allows for the buying and selling of a stock index for a specified price at a specified date

Available for various stock indexes (see next slide) Have four settlement dates on the third Friday in March, June, September, and December The securities underlying the stock index futures are not deliverable; settlement occurs through a cash payment The net gain or loss is the difference between the futures price when the initial position was created and the value of the contract on the settlement date Some speculators prefer to trade stock index futures rather than actual stocks because of the smaller transaction costs

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Stock Index Futures (contd)

Type of Stock Index Futures Contract S&P 500 index Mini S&P 500 index Contract Is Valued As: $250 times index $50 times index

S&P Midcap 400 index

S&P Small Cap index Nasdaq 100 index Mini Nasdaq 100 index Mini Nasdaq Composite index Nikkei 225 index Russell 2000 index

$500 times index

$200 times index $100 times index $20 times index $20 times index $5 times index $500 times index
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Stock Index Futures (contd)

Valuing stock index futures contracts

The value of a stock index futures contract is highly correlated with the value of the underlying stock index The value of a stock index futures contract commonly varies from the value of the underlying index

The price of index futures contracts is driven by the underlying asset and the cost of carry (the net financing cost to buy the index) In general, the underlying security changes by a much greater degree than the cost of carry, so changes in financial futures prices are primarily attributed to changes in the values of the underlying securities

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Stock Index Futures (contd)

Valuing stock index futures contracts (contd)

Indicators monitored by participants in stock index futures

Participants in the futures market monitor indicators that may signal changes in the stock indexes

Speculating with stock index futures

Stock index futures can be traded to capitalize on expectations about stock market movements

If the market is expected to increase, buy stock index futures If the market is expected to decrease, sell stock index futures

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Speculating with Stock Index Futures

Jimmy Dean expects the S&P 500 index to increase in the near future. Thus, Jimmy decides to purchase an S&P 500 futures contract with a December settlement date. The current futures price is 1,200. If the futures price rises to 1,250 by the settlement date, what is Jimmys nominal profit?
Profit $312,500 $300,000 $12,500

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Stock Index Futures (contd)

Hedging with stock index futures

Futures

can be used to hedge the market risk of an existing stock portfolio

Sell stock index futures if the existing portfolio is expected to decline Buy stock index futures if the existing portfolio is expected to increase

The

hedge is more effective when the portfolio is diversified

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Stock Index Futures (contd)

Hedging with stock index futures (contd)

Test of suitability of stock index futures

Usefulness can be assessed by measuring the sensitivity of the portfolios performance to market movements Determine whether a hypothetical derivative position would have offset adverse market effects on the portfolios performance Portfolio managers may be partially exposed in the event the stock price rises The higher the proportion of the portfolio that is hedged, the more insulated the managers performance is from market conditions

Determining the proportion of the portfolio to hedge

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Stock Index Futures (contd)

Dynamic asset allocation with stock index futures

In dynamic asset allocation, investors switch between risky and low-risk investment position in response to changing expectations

e.g., buy stock index futures if favorable market conditions are expected

Prices of stock index futures versus stocks

Prices of index futures and the index can differ to some degree Recent studies have found a high degree of correlation between the stock index futures and the index itself

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Stock Index Futures (contd)

Arbitrage with stock index futures

Program

trading in conjunction with the trading of stock index futures is known as index arbitrage
Securities firms act as arbitrageurs and attempt to capitalize on discrepancies between prices of index futures and stocks Index arbitrage involves the buying or selling of stock index futures with a simultaneous opposite position in the stocks that the index comprises

Instigated when futures prices differ significantly from the stock represented by the index

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Stock Index Futures (contd)

Circuit breakers on stock index futures

Circuit

breakers are trading restrictions imposed on specific stocks or stock indexes The CME imposes circuit bakers on the S&P 500 futures contract Circuit breakers allow investors to determine whether circulating rumors are true and to work out credit arrangements if they have received a margin call

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Single Stock Futures

A single stock futures contract is an agreement to buy or sell a specified number of shares of a specified stock on a specified future date Nominal size of a contract is 100 shares Investors can buy or sell futures through their broker Settlement dates are on the third Friday of March, June, September, and December for the next 5 quarters, as well as the nearest two months Investors can buy single stock futures on margin Single stock futures are regulated by the Commodity Futures Trading Commission (CFTC) and the SEC Investors can close out their position at any time by taking the opposite position OneChicago is a joint venture between the CBOE and the CBOT which serves as another market for trading single stock futures

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Risk of Trading Futures Contracts

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

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Regulation in the Futures Markets

Systemic risk is the risk that a particular even could spread adverse effects among several firms or among financial markets Regulators have attempted to reduce systemic risk by:

Ensuring that participants in derivative markets have adequate collateral to back their positions Ensuring that participants fully disclose their exposure to risk resulting from derivative positions

The Fed monitors commercial banks capital Accounting regulators revised accounting standards in 1994 to require more disclosure about derivative positions

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Institutional Use of Futures Markets

Type of Financial Institution
Commercial banks Savings institutions Securities firms

Participation in Futures Markets

Take positions in futures contracts to hedge against interest rate risk Take positions in futures contracts to hedge against interest rate risk Execute futures transactions for individuals and firms Take positions in futures contracts to hedge their own portfolios against stock market or interest rate movements Take positions in futures contracts to speculate on future stock market or interest rate movements Take position in futures contracts to hedge their portfolios against stock market or interest rate movements Take positions in futures contracts to hedge their portfolios against stock market or interest rate movements Take positions in futures contracts to hedge their portfolios against stock market or interest rate movements
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Mutual funds

Pension funds Insurance companies

Globalization of Futures Markets

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 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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Foreign stock index futures

Globalization of Futures Markets (contd)

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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