Financial Futures Markets Background on Financial Futures •Large return with a high degree of risk •Reduction of risk for large institutions •Facilitate the trading of financial futures contracts •A financial futures contract •Standardized agreement to deliver or receive a specified financial instrument at a specified price and date •Buyer of the contract buys the financial instrument •Seller of the contract deliver the financial instrument at specified time Background on Financial Futures •Futures are a derivative security •Derivatives • Securities whose value is derived from the value of some underlying asset or financial instrument •Derivative security prices related to factors affecting prices in the spot market •For example, bond futures prices are related to what is happening in markets where bonds are bought and sold for immediate delivery • Background on Financial Futures •Traded on organized exchange •Futures exchange •Clear, settle and guarantee all transactions that occur on their exchange •Provide liquidity •Regulated by Commodity Futures Trading Commission (CFTC) •Approve contracts before listing of futures exchanges •Regulation to prevent unfair trading practices Background on Financial Futures •Interest rate futures vs. Stock index futures •Sellement dates •March, June, September, December Purpose of Trading Financial Futures •Speculators •Take position to profit from expected changes in the price of futures contracts over time •Take a position with the goal of profiting from expected changes in the contract’s price •No position in underlying asset •Hedgers •Take position to reduce their exposure to future movements in interest rates or stock prices. •Minimize or manage risks •Have position in spot market with the goal to offset risk •Hedgers and Speculators serve as the counterparty on many futures transactions •Speculators provide liquidity • Purpose of Trading Financial Futures •Speculators •Day traders •Position traders Structure of the Futures Market •In the U.S. •CME group •2007 merge of the Chicago Board of the Trade and the Chicago Mercantile Exchange •The large and the most diversify derivative exchange • Commission brokers (floor brokers) •Floor traders (locals) •OTC Trading •Electronic Trading Trading Futures •Open accounts at brokerage firms •Margin deposit •Initial margin 5 – 18 percent of a future contract’s full value •Marked to market daily •Type of order •Market order •Limit order Institutional Use of Futures Markets •Most activity is for hedging, not speculating •Many kinds of institutions uses futures •Commercial banks •Savings institutions •Securities firms •Mutual funds •Pension funds •Insurance companies • Institutional Use of Futures Markets • Valuation of Financial Futures •Futures contract price related to the price of the underlying asset •Inverse relationship between debt contract prices and interest rates applies to futures prices •Futures contract price reflects the expected price of the underlying asset or index as of the settlement date •Anything that affects the price of the underlying asset affects the futures price •Impact of opportunity costs or benefits Profit or Loss from Selling a Futures Contract Market V alue of the Futures Contract as of the Settlement Date S 0 Profit or Loss from Purchasing a Futures Contract Market V alue of the Futures Contract as of the Settlement Date S 0 Potential Payoffs in Financial Futures Speculating with Interest Rate Futures •Forecasts that interest rates will decrease •Value of T-bills should increase •Buy a T-Bill futures contract (94.00 a 6 percent discount) •T-bill futures represent $1 million of par value •1. T-Bill price on Marche settlement date is 94.90 (5.1 percent discount) •Investor can accept delivery of the T-bills and sell them for more than he paid for them. • Speculating with Interest Rate Futures •2. T-Bill price on Marche settlement date is 92.50 (7.5 percent discount) Impact of Leverage •Use a margin account •Return should reflect the degree of financial leverage • http://image.slidesharecdn.com/derivativesandriskmanagementleft-handfinancing-120629164123-phpapp02 /95/derivatives-and-risk-management-left-hand-financing-39-728.jpg?cb=1341006231 Using Interest Rate Futures to Create a Short Hedge – Financial Institutions usage •Hedger adversely affected by an interest rate increase •Bank using primarily short-term funds to finance longer-term assets •Hurt by rising rates; must refinance funding before investment re-priced • Using Interest Rate Futures to Create a Short Hedge •The short hedge •Sell futures contracts with characteristics similar to the securities being hedged •If rates increase, hedger closes out the position at a profit in the futures market to offset spot market position opportunity loss (reduced interest margin) •If rates decrease, hedger’s spot market gains (wider interest margin) offset by losses on the futures position • Hedging with Interest Rate Futures •Interest rate risk exposure •Classification of assets and liabilities according to their sensitivity of their market value Probability Distribution od Returns Using Interest Rate Futures to Create a Long Hedge •Examples of adverse effects of a decrease in interest rates •Plan to purchase debt securities in a few months and if rates decline, the purchase price of bonds increases—long futures position locks in price of bonds •Bank finances loans whose rates adjust every six months with CDs that have a two-year term—long futures position locks in loan rates to maintain spread •Hedger uses futures position to offset spot losses and gains—locks in a price or spread • Hedging net exposure •Futures hedges have transaction costs •Net exposure is the difference between asset and liability positions • Stock Index Futures •Types of index futures contracts •Several different index contracts traded on the Chicago Board of Trade and Chicago Mercantile Exchange •Securities underlying the contract not deliverable-- cash settlement •Contract’s price is the index times the dollar value given in the contract’s specifications •For example, Chicago Merc S&P contract is the index value times $250 • Stock Index Futures Contracts Stock Index Futures •Value of futures contract highly correlated with the value of the underlying index •Differences or advantages and disadvantages to owning the actual index versus futures •Under some circumstances, arbitrage profits are possible •Indicators monitored by the market include anything affecting the underlying index Stock Index Futures •Speculating with stock index futures •Capitalize on expectations without having sufficient cash to buy the actual stocks in index •Expect an increase in stock prices, buy index futures; gain/losses leveraged with small investment •Hedging with stock index futures •Hedge market risk of an existing portfolio •Pension fund manager with reasonable return for year sells index futures contracts to lock in return Stock Index Futures •Hedging issues •Hedge is more effective if investor’s portfolio is diversified like the underlying index for the futures contract •Portfolio managers do not necessarily hedge the entire portfolio • Stock Index Futures •Circuit breakers on stock index futures •Suspends trading on specific stocks or stock indexes after a specified market decline •Gives investors a chance to evaluate information or meet margin calls before trading resumes •Impacts program trading which has been linked to market volatility • Risk of Trading Futures Contracts •Market risk •Speculators win or lose based on changing market value of futures contracts •Hedgers, with a position in the underlying asset, are not significantly impacted by contract price volatility •Basis risk •Futures contract prices do not vary in exactly the same way as the underlying asset’s price •Price correlation of contract and underlying asset impacts the ability to hedge market risk • Risk of Trading Futures Contracts •Dealing with basis risk •Identify futures contract with price changes closely related to the underlying asset •Cross hedging involves using a futures contract with an underlying asset different from the asset to hedge, for example, hedge commercial paper rate exposure with T-bills futures •Liquidity risk •Price distortions if a contract is not widely traded •Need a counterparty to close position • Risk of Trading Futures Contracts •Credit risk •Counterparty defaults •Not a risk on exchange-traded contracts where exchange serves as the counter-party •Prepayment risk •Assets (e.g. loans) prepaid sooner than their designated maturity •Leaves hedger without an offsetting spot position in a speculative position • Risk of Trading Futures Contracts •Operational risk •Inadequate management or controls •For example, hedging firm’s employees do not understand how futures contract values respond to market conditions •