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FIN221: Lecture 11 Noters Futures

Chapter 18 Chapter 18
Charles P. Jones, Investments: Analysis and Management,
Eighth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University

Understanding Futures Markets Understanding Futures Markets

Spot or cash market Futures market characteristics
Price refers to item available for immediate Centralized marketplace allows investors to
delivery trade each other
Forward market Performance is guaranteed by a
Price refers to item available for delayed clearinghouse
delivery Valuable economic functions
Futures market Hedgers shift price risk to speculators
Sets features (contract size, delivery date, Price discovery conveys information
and conditions) for delivery

Understanding Futures Markets Futures Contract

Commodities - agricultural, metals, and A obligation to buy or sell a fixed amount
energy related of an asset on a specified future date at a
Financials - foreign currencies as well as price set today
debt and equity instruments Trading means that a commitment has been
made between buyer and seller
Foreign futures markets
Position offset by making an opposite contract
Increased number shows the move toward
in the same commodity
Markets quite competitive with US Commodity Futures Trading Commission
regulates trading

Futures Exchanges The Clearinghouse
Where futures contracts are traded A corporation separate from, but
Voluntary, nonprofit associations, of associated with, each exchange
membership Exchange members must be members or
Organized marketplace where established pay a member for these services
rules govern conduct Buyers and sellers settle with clearinghouse,
Funded by dues and fees for services not with each other
rendered Helps facilitate an orderly market
Members trade for self or for others Keeps track of obligations

The Mechanics of Trading The Mechanics of Trading

Through open-outcry, seller and buyer Contracts can be settled in two ways:
agree to take or make delivery on a future Delivery (less than 2% of transactions)
date at a price agreed on today Offset: liquidation of a prior position by an
Short position (seller) commits a trader to offsetting transaction
deliver an item at contract maturity Each exchange establishes price
Long position (buyer) commits a trader to fluctuation limits on contracts
purchase an item at contract maturity
No restrictions on short selling
Like options, futures trading a zero sum game
No assigned specialists as in NYSE

Futures Margin Futures Margin

Earnest money deposit made by both Margin calls occur when price goes
buyer and seller to ensure performance of against investor
obligations Must deposit more cash or close account
Not an amount borrowed from broker Position marked-to- market daily
Each clearinghouse sets requirements Profit can be withdrawn
Brokerage houses can require higher margin Each contract has maintenance or
Initial margin usually less than 10% of variation margin level below which earnest
contract value money cannot drop

Using Futures Contracts Hedging
Hedgers Short (sell) hedge
At risk with a spot market asset and exposed Cash market inventory exposed to a fall in
to unexpected price changes value
Buy or sell futures to offset the risk Sell futures now to profit if the value of the
Used as a form of insurance inventory falls
Willing to forgo some profit in order to reduce Long (buy) hedge
risk Anticipated purchase exposed to a rise in cost
Hedged return has smaller chance of low return Buy futures now to profit if costs increase
but also smaller chance of high

Hedging Risks Using Futures Contracts

Basis: difference between cash price and Speculators
futures price of hedged item Buy or sell futures contracts in an attempt
to earn a return
Must be zero at contract maturity
No prior spot market position
Basis risk: the risk of an unexpected Absorb excess demand or supply
change in basis generated by hedgers
Hedging reduces risk if basis risk less than Assuming the risk of price fluctuations that
variability in price of hedged asset hedgers wish to avoid
Risk cannot be entirely eliminated Speculation encouraged by leverage, ease
of transacting, low costs

Financial Futures Financial Futures

Contracts on equity indexes, fixed income At maturity, Tbond and Tbill interest rate
securities, and currencies futures settle by delivery of debt
Opportunity to fine-tune risk-return instruments
characteristics of portfolio If expect increase (decrease) in rates, sell
(buy) interest rate futures
At maturity, stock index futures settle in
Increase (decrease) in interest rates will decrease
cash (increase) spot and futures prices
Difficult to manage delivery of all stocks in a Difficult to short bonds in spot market
particular index

Hedging with Stock Index
Program Trading
Selling futures contracts against diversified Index arbitrage: a version of program
stock portfolio allows the transfer of trading
systematic risk Exploitation of price difference between stock
Diversification eliminates nonsystematic risk index futures and index of stocks underlying
Hedging against overall market decline futures contract
Offset value of stock portfolio because futures Arbitrageurs build hedged portfolio that earns
prices are highly correlated with changes in low risk profits equaling the difference
value of stock portfolios between the value of cash and futures

Speculating with Stock Index Speculating with Stock Index

Futures Futures
Futures effective for speculating on Futures contract spreads
movements in stock market because: Both long and short positions at the same
Low transaction costs involved in establishing time in different contracts
futures position Intramarket (or calendar or time) spread
Stock index futures prices mirror the market Same contract, different maturities
Traders expecting the market to rise (fall) Intermarket (or quality) spread
buy (sell) index futures Same maturities, different contracts
Interested in relative price as opposed to
absolute price changes