10.

Financial Futures Markets

Futures Contracts
• Exchange traded products
• Regulated by the CFTC
• Types of Futures
– Commodity Futures
– Financial Futures
• stock index futures
• interest rate futures
• currency futures
• The value of a futures contract is derived from the value
of the underlying instrument

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Futures Contracts
• A firm legal agreement between a buyer
(seller) and an established exchange or its
clearing house in which:
– the buyer agrees to take delivery of an asset at a
specified price at the end of a designated period of
time.
– the seller agrees to make delivery of an asset at a
specified price at the end of a designated period of
time.

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Futures Contracts
• Key Elements
– Futures Price
– Settlement Date or Delivery Date
– Underlying Asset
• Futures Positions
– Long futures
– Short futures

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Liquidating a Futures Position
• Settlement Dates
– March, June, September, December
– Nearby futures contracts
– Most distant futures contracts

• Liquidating a Futures Position

– Take an offsetting position in the same contract prior to the
settlement date
– Take delivery of the underlying asset on the date of settlement

• Open Interest
- The number of contracts that not yet liquidated

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Role of Clearing House
• Functions of Clearinghouse
– guarantees that both parties to futures contracts
satisfy their obligations
– simplifies the unwinding of futures positions prior to
the settlement date

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Margin Requirements
• Initial Margin
– minimum dollar amount per futures contract
– provides investor with substantial leverage
• Maintenance Margin
– minimum level to which an equity position may fall
due to adverse price movements
• Variation Margin
– amount necessary to bring equity account back to
initial margin level

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 Daily Settlement
• Futures contracts are marked-to-market on a
daily basis
– a buyer (seller) realizes a profit if the futures price
increases (decreases)
– a buyer (seller) realizes a loss if the futures price
decreases (increases)
• Daily price limits restrict the maximum daily
price moves

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Market Structure
• Exchange Trading
– Pit
– Seat on the exchange
• Floor Traders
– Locals
– Floor or pit brokers
– Futures commissions merchant
• Electronic Trading Systems

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Futures vs Forward Contracts

• Type of Contract • Delivery

• Trading Location • Collateral
• Clearinghouse • Credit Risk
• Settlement

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Pricing of Futures Contracts

Consider a futures contract with the underlying asset XYZ:

1. In the cash market Asset XYZ is selling for $100
2. Asset XYZ pays the holder $12 per year in four quarterly
payments of $3, and the next payment is exactly 3
months from now.
3. The futures contract requires delivery 3 months from now
4. The current 3-month interest rate at which funds can be
loaned or borrow is 8% per year

What should the price of this futures contract be? Or what

should the futures price be?

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Suppose the price of the futures contract is $107.
Consider this strategy:
- Sell the futures contract at $107
- Purchase Asset XYZ in the cash market for $100
- Borrow $100 for 3 months at 8% per year

Three months from now, Asset XYZ must be delivered to settle

the futures contract, and the loan must be repaid.

This strategy produces an outcome as follows:

1. From settlement of the futures contract
Proceed from sale of Asset XYZ $107
Payment received from investing in Asset XYZ for 3 months 3
Total proceeds $110
2. From the loan
Repayment of principal of loan $100
Interest on loan (2% for 3 months) 2
Total outlay $102
Profit = $110 - $102 = $8
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Suppose the price of the futures contract is $92.
Consider the following strategy:
- Buy the futures contract at $92
- Sell (short) Asset XYZ in the cash market for $100
- Invest (lend) $100 for 3 months at 8% per year

Three months from now, Asset XYZ must be purchased to settle

the futures contract, and receive proceeds from the loan.

This strategy produces an outcome as follows:

1. From settlement of the futures contract
Price paid for purchase of Asset XYZ $ 92
Proceeds to lender of Asset XYZ 3
Total outlay $ 95
2. From the loan
Proceeds received from maturing of investment $100
Interest on earned from the 3-month loan investment 2
Total outlay $102
Profit = $102 - $95 = $7
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Will a specific futures price eliminate the riskless arbitrage profit?
Yes, no arbitrage profit can be realized if the futures price is $99.
Consider the following strategy:
- Sell the futures contract at $99
- Purchase Asset XYZ for $100
- Borrow $100 for 3 months at 8% per year

In 3 months the outcome will be as follows:

1. From settlement of the futures contract
Proceed from sale of Asset XYZ $ 99
Payment received from investing in Asset XYZ for 3 months 3
Total proceeds $102
2. From the loan
Repayment of principal of loan $100
Interest on loan (2% for 3 months) 2
Total outlay $102
Profit = $102 - $102 = $0
No arbitrage profit results from this strategy.

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Suppose the price of the futures contract is $92.
Consider the following strategy:
- Buy the futures contract at $99
- Sell (short) Asset XYZ in the cash market for $100
- Invest (lend) $100 for 3 months at 8% per year

The outcome in 3 months would be as follows:

1. From settlement of the futures contract
Price paid for purchase of Asset XYZ $ 99
Proceeds to lender of Asset XYZ 3
Total outlay $ 102
2. From the loan
Proceeds received from maturing of investment $100
Interest on earned from the 3-month loan investment 2
Total outlay $102
Profit = $102 - $102 = $0

Thus, neither strategy results in an arbitrage profit. A futures price of

$99 is the equilibrium price or also called theoretical futures price
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Theoretical Futures Price
Suppose: r = financing cost (borrowing and lending rate)
y = cash yield
P = cash market price ($)
F = futures price ($)
Consider the strategy:
- Sell the futures contract at F
- Purchase Asset XYZ for P
- Borrow P until the settlement date at r

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The outcome at the settlement date then is:

1. From settlement of the futures contract

Proceed from sale of Asset XYZ F
Payment received from investing in Asset XYZ for 3 months yP
Total proceeds F + yP
2. From the loan
Repayment of principal of loan P
Interest on loan (2% for 3 months) rP
Total outlay P + rP

Profit = Total proceeds – Total outlay = F + yP – (P + rP)

In equilibrium:
0 = F + yP – (P + rP)
F = P + P(r-y)  the theoretical futures price
Example: r = 0.02, y = 0.03, P = $100
F = $100 + $100(0.02 – 0.03) = $100 - $1 = $99

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Consider the alternative strategy:
- Buy the futures contract at F
- Sell (short) Asset XYZ for P
- Invest (lend) P at r until the settlement date

The outcome at the settlement date then is:

1. From settlement of the futures contract

Price paid for purchase of Asset XYZ F
Payment to lender of Asset XYZ yP
Total outlay F + yP
2. From the loan
Proceeds received maturing of the loan investments P
Interest earned rP
Total proceeds P + rP

Profit = Total proceeds – Total outlay

= P + rP – (F + yP)
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Differences Between Lending and Borrowing Rates

Typically, in deriving the theoretical futures price, the borrowing

rate is greater than the lending rate. Let rB = borrowing rate, rL =
lending rate and using the strategy:
- Sell the futures contract at F
- Purchase the asset for P
- Borrow P until the settlement date at rB
the futures price that would produce no arbitrage profit is
F = P + P(rB – y)  upper boundary

For the strategy:

- Buy the futures contract at F
- Sell (short) the asset for P
- Invest (lend) P at rL until the settlement date

the futures price that would produce no profit is

F = P + P(rL – y)  lower boundary
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Example:
Assume the borrowing rate is 8% per year or 2% for 3
months, while the lending rate is 6% per year or 1.5% for 3
months.

F(upper boundary) = $100 + $100(0.02 – 0.03) = $99

F(lower boundary) = $100 + $100(0.015 – 0.03) = $98.50

Thus the theoretical futures price must satisfy the condition:

98.50 < F < 99

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Hedging with Futures
Assume that a gold mining company expects to sell 1,000 ounces of gold 1
week from now and that the management of jewelry company plans to
purchase 1,000 ounces of gold 1 week from now. The two parties want to
lock in today’s price – that is, they both want to eliminate the price risk
associated with gold 1 week from now. The spot price for gold is $352.40
per ounce. The futures price is currently $397.80 per ounce. Each futures
contract is for 100 ounces of gold.

Because the gold mining company seeks protection against an increase in

the price of gold, it will place a short hedge. The company will sell 10
futures contracts.

Since the jewelry company seeks protection against an increase in the price
of gold, it will place a long hedge. Thus it will buy 10 contracts.

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Perfect Hedge
Suppose at 1 week from now (the time the hedge is lifted) the cash
price has declined to $304.20 and the futures price has declined to
$349.60. The gold mining company wanted to lock in a price of
$352.40 per ounce of gold, or $352,400 for 1000 ounces. The company
sold 10 futures contracts at a price of $397.80 per ounce or $397,800
for 1000 ounces. When the hedge is lifted the value of 1000 ounces of
gold is $304,200. The gold mining company realizes a decline in the
cash market in the value of its gold of $48,200.

However the futures price has declined to $349,600 for 1000 ounces.
The mining company thus realizes a $48,200 gain in the futures
market. The net result is that the gain in the futures market matches
the loss in the cash market. This is a perfect short hedge.

For the jewelry company, it gains in the cash market by $48,200 but
realizes a loss of the same amount in the futures market. This is a
perfect long hedge.

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 The Role of Futures in Financial
Markets

• Altering Risk Exposure of an Asset

• Price Discovery
• Arbitrage Process
• Increased Price Volatility of Underlying
Asset

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US Financial Futures Markets
• Stock Index Futures Market
• Interest Rate Futures Market
– Treasury Bill Futures
– Eurodollar CD Futures
– Treasury Bond Futures
– Treasury Note Futures
– Agency Futures

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Assignment

1. Explain why you agree or disagree with the

following statement: ‘Hedging with futures
involves substituting basis risk for price risk.”
2. What is the destabilization hypothesis, and what
are the two variants of this hypothesis?

Note:
To be collected next week

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