Futures Markets and Contracts

- They are standardised ‘forward contracts’

- Traded on the organised exchange.
A futures contract is an agreement between two parties in which one party, the buyer, agrees
to buy from the other party, the seller an underlying asset or other derivative at a future date
at a price agreed on today.

 Unlike a forward contract however, a futures contract is not a private and customised
transaction but rather a public transaction that takes place on a organised futures
exchange.
 In addition, a futures contract is standardised, i.e. the exchange rather than the
individual parties set the sterms and conditions with the exception of price. As a
result futures contracts have a secondary market meaning that previously created
contracts can be traded.
 Also parties to futures contracts are guaranteed against credit losses resulting from the
counter party’s inability to pay.
 A clearing house provides this guarantee via a procedure in which it converts gains
and losses that accrue on a daily basis into actual cash gains and loses.
 Everyday the futures contract trade in the market and its price changes in response to
new information.
 Buyers benefit from price increases and sellers from price decreases.
 On the expiration day, the contract terminates and no further trading takes place.
 Either the buyer takes delivery of the underlying to the seller or two parties make an
equivalent cash settlement.

History of the Futures Market

In 1848 a group of business man formed an organisation later called Chicago Board of Trade
and created an arrangement called ‘To Arrive Contract”. These contracts permitted farmers
to sell their grain before delivering it, that is in other words, farmers could harvest the grain
and enter into a contract to deliver it at a much later date at a price already agreed on. This
transaction allowed the farmers to hold the grain in storage at some other location besides
Chicago. It soon became ap[parent that trading in these “to arrive Contracts” was more
important than trading in grain itself. With the addition of a clearing house in the 1920s,
which provided a guarantee against default modern futures firms established their plan in the
financial world.

Examples of futures exchange include:

1. Chicago board of Traders
2. Chicago Mercantile Exchange
3. LIFFE
4. South African Futures Exchange e.t.c.

Features of a Futures Contract

1) Standardised Transaction
A futures transaction is reported to the futures exchange the clearing house and at least one
regulatory agent. The price is rewarded and is available from price reporting services or even
on the internet. The information reported to the public does not report or disclose the identity
of the parties to the transaction but only that a transaction took place at a particular price. In
a futures contract the price is the only term established by the two parties, the exchange
established by the other terms. More over the terms that are established by the exchange are
standardised.

2) Expiration dates
For a futures contract the exchange establishing a set of expiration dates. The fist
specification of the expiration is the month e.g. March. June. September, December. The
second is the expiration day. Many but not all contracts expire during the 3 rd week of the
expiration month.

3) Contract Size
For example, one futures contract on crude oil covers 1000 barrels.

4) Homogeneity and Liquidity

The font that the instruments are standardised make it acceptable to a broader group of
participants, with the advantage being that the instruments can more easily trade in the
secondary market.

The Clearing House Daily Settlement and performance Guarantee

The futures exchange guarantees to each party the performance of the other party through a
mechanism known as clearing house. This guarantee means that if one party makes money
on the transaction, he does not have to worry about whether he will be able to collect the
money from the other party because the clearing house guarantees that it will be paid. An
important feature o the futures contract is that the gains or losses on each party’s position are
credited are charged on a daily basis, that is market to market.

Regulation of the Futures Market

In most futures contracts are regulated at the government level. In the
 USA the commodity futures Trading Commission regulates commodity futures
markets.
 In the UK – the Financial Services Authority (FSA) regulate the futures market.
 In South Africa – the Financial Services board regulates the futures market.

Example: A producer agrees to deliver one million barrels of oil to an oil export at $100 per
barrel at some future date. The trader takes a long position of 10 contracts on day O,
depositing $10 which is ($5 times contracts).

We start with the assumption that the futures price is $100 when the transaction opens. The
initial margin requirement is $5 and the maintenance margin is $3.

Although the trader can withdraw any funds in excess of the initial margin requirements we
shall assume that he does no do so.

Day Beginning Funds Settlement Futures Gain/Loss Ending

Balance Deposited Price Price Balance
Change
0 0 50 100 - - -
1 50 - 99.20 -0.80 -8 42
2 42 - 96.00 -3.20 -32 10
3 10 40 101.00 +5 50 100
4 100 - 103.50 +2.50 25 125
5 125 - 103.00 -0.50 -5 120
6 120 0 104.00 +1 10 130

Example:
Consider a futures contract in which the current prize is $82. The initial margin requirement
is $5 and the maintenance margin is $2. You go long 20 contracts and meet all margin calls
but do not withdraw ant excess margin. Assume that on the first day the contract is
established at the settlement prize so that there is no mark to market gain that day.

Day Beginning Funds Settlement Futures Gain/Loss Ending

Balance Deposited Prize Price Balance
Change
0 0 100 82 - -100
1 100 84 +2 +40 140
2 140 78 -6 -120 20
3 20 80 73 -5 -100 0
4 0 100 79 6 120 120+100=220
5 220 82 +3 60 280
6 280 84 +2 40 320

Types of Futures Contracts

1) Commodity Futures
2) Financial Futures

Financial Futures
(i) Interest rates futures contracts
(ii) Currency rates future contracts
(iii) Stock index futures contracts

(i) Short term interest rate futures contracts

The primary short term interest rate futures are those on US Treasury bills and
Euro Dollars on the Chicago Mercantile Exchange.

(a) Treasury Bill Futures- The treasury bill

- Contract launched in 1976 was the first interest rate futures contract.
- It is based on a 90 day US Treasury bill, one of the most important US government
debt instrument. The treasury bill is a discount instrument meaning that its prize =
face value
 - The discount = face value x quoted rate x the days to maturity divided by 360. Thus
if a 180 dya treasury bill is selling at a discount of 4%, its prize per $1 par is

1−0 ,04 ( 180

360 )
=$ 0. 98.

- An investor who holds the bill to maturity would receive $1 ant maturity netting a
given of $0,02. The futures contract is beized on a 90 day $1 million US treasury
(TB). Thus on any day, the contract trades with the understanding that a 90 day. TB
will be delivered at expiration.
- While the contract is trading, its price is quoted as “100 – the rate quoted as a percent”
priced into the contract by the futures market. This value is known as the IMM index.
The IMM index is a reported and publicity available price, however it is not the actual

90
(
futures price which is 1 00 1−rate x
30 )
For example: Suppose on a given date, the rate priced on the contract is 6,25%. The quoted
price will be 100-6,25 = 93,75.
The actual futures price will be:
90
(
1000 0 00 x 0 , 0625 x
360 )
=984375.

90
1000 00 0 x ( 1−0 , 0625 x
360 )
=984375

b) Eurodollar Futures
the 3 months Eurodollar futures contract traded on the CME is one of the most liquid
financial futures contracts in the world. It is widely used by financial institutions to hedge
short term interest rate possures or to take a leveraged position in anticipation of a rise or fall
in interest rates.
The CME contract is based on the LIBOR rate on a notional $1 million Euro dollar deposit
starting at a specific date in the future. While the contract is trading, its prize is quoted as 100
the rate priced into the contract by futures traders.
For example’
If the rate priced into the contract is 5,25% the quoted price will be 100-5,25%=94,75%.
With each contract based on $1 million notional principal of Euro dollars, the actual futures

90
[
price is $ 1000 000 1−0 , 05 25 ( 360 )]=986875 , 00
(c) Stock Index Futures Contract
One of the most successful types of futures contracts of all times is the class of futures on
stock indices. The most successful has been the Chicago Mercantile Exchange’s contract on
the standard and poor 500 (S&P500).
FTSE 100, NIKKEI, DAX

Called the S & P 500 stock index futures, this contract premiered in 1982 and has benefit
from widespread acceptance of the S & P 500 index as a stock market benchmark. The
contract is quoted in terms of the price on the same order of magnitude as the S & P 500
itself.

Example

If the S &P 500 index is at 1183, a two months futures contract might be quoted at a price of
say 1187. The contract implicitly contains a multiplier which is appropriately multiplied by
the quoted price to produce the actual futures price. The multiplier for the S&P500 is $250
thus for a future price of 1187 the actual price is 1187x$250= $296 750.

The S &P500 futures expirations are March, June, September and December.

(d) Currency futures contracts

Currency futures were the first futures contracts not based on physical commodities and their
initial success paved the way for the later introduction of interest rate and stock index futures
compared with forward contracts on currencies, currency futures contracts are much smaller
in size.

Pricing and valuation of futures contracts

(i) Futures contracts on a security with no income. When they are no distributions
from the underlying asset, the cost of carry is equal to riskless interest rate. The
futures price is given by: F= SerT. More generally the relation represents the
forward or futures price as a function of the spot prices. It applies to the valuation
of forwards or futures contracts an a security their provides no income, e.g
 Example

Consider the futures contract on a non-dividend paying stock. Suppose the maturity date
is in 3 months the current asset price is $100 and the 3 months risk free rate is 7% per
annum. In this case: S=100

R =0,07

3
T= = 0,25 years
12

The future price = SerT = 100 e0,07x0,25

= 101,7654

ii) Futures contracts on a security with known Income.

For dividend paying assets the cost of carrying the stocks is given by the difference
between the risk less rate and the dividend yield d. This gives the following relation:

F = Se(r-d)T

This relationship gives the futures price F as a the function of the spot price S for a
forward or futures contract on a security that provides a known dividend yield.

e.g

Consider the valuation of a 3 months futures contract on a security that provides a continuous
dividend yield of 5% per annum. Suppose the current asset price is $100 and the risk free rate
is 7% per annum.

S =100
T = 0,25 years
r =0,07
d =0,05
F = Se(r-d)T= 100 e(0,07-0,05)x0,25
= 100, 5012521

(iii) Futures Contracts on Foreign Currencies

The cost of carrying a foreign currency is given by the difference between the domestic
riskless rate and the foreign riskless rate, r* this gives the following relation between the
futures price and the spot price of the currency:
F=Se(r-r*)T
This relationship also gives the futures price F (or foreign exchange rate F) as a function of
the spot price S for a forward contract in a currency.
This is often known in international finance as the interest rate parity theorem;
For example;
Consider the valuation of a 3 months forward or futures contract on a foreign currency: If the
spot price is 180, the domestic riskfree rate is 6% p.a. and the foreign risk free rate is 7% p.a..
Then
S=180
T=0,25
r=0,07
r*=0,06

F=180e(0,07-0,06)x0,25
= 180,45

3(iv)
Question

The spot exchange rate for the Swiss Frank is $0,60. The US interest rate is 6% and the Swiss
interest rate is 5%. A futures contract expires in 78 days. Find the appropriate future price.

F = 0,60e(0,06-0,05)x0,2166666
= 0,60130
78

[
¿
(
1+0 , 06 x

1+0 , 05 x

1,013
360
78
360
)
]
1,01083333

= 0,6013

CHF 1 :$0,60
Counter currency
Base currency

Exam questions
APPLICATION

RISK MANAGEMENT OF FUTURES STRATEGIES

The Managing of risk of an Equity Portfolio

We consider the specific problem of an equity portfolio manager from the risk of an adverse
movement of the overall stock market. Have the risk manager wishes to establish a short
ledger position to reduce risk and must determine the number of futures contracts required to
properly ledge a portfolio. In this hedging example;

You are responsible for managing a broadly diversified stock portfolio with a current
portfolio valued at $185 million. Analysis if the market conditions leads you to believe the
market is unusually vulnerable to a price decline during the next few months. A fundamental
problem however is that no futures contract exactly matches as a result you decide to protect
your stock portfolio from a fall in value caused by failing stock market, using stock index
futures this is an example of a cross- hedge, where a futures contract on a related but not
identical commodity or financial instrument is used to hedge a particular spot stock
positioning thus to hedge the portfolio you wish to establish a short hedge using stock index
futures. (Beta of Market Portfolio is 1.)

To do this one needs to know how many index futures contracts one needed to form an
effective hedge
- Three basic impacts are needed to calculate the number 6 index futures to hedge the
stock portfolio.
1. The current value of the stock portfolio.
2. The Beta of your stock portfolio
3. The contract value of the index Futures contract used for hedging.

Beta measures the portfolio risk relative to the stock market.

- We assume a Beta of 1,25 to the stock portfolio of $185million.
- You believe that the market & your portfolio will fall in value over the next 3 months
and you decide to eliminate the market risk from your portfolio that is you would like
to convert your risk portfolio with a Beta of O. A riskless is like Treasury Bill
(conventional Bills) 0.
- Because you hold a stock portfolio, you know that you need to establish a short hedge
using Future contracts.
- You decide to cede Futures contracts on the S&P Index and find that the S&P Futures
price for contracts that mature in 3 months is $1480
- Because the contract size for the S& P Futures is $250 times the index level, the
current value of single S&P500 Index futures is 250x1480 = $370 000.
- The number of stock index futures contracts needed to convert Beta of the portfolio
from 1,25 to 0 is determined by the following formula:

VP
Number of contracts = (BD-BP) x
�敲 � F

Where: BD =Desired Beta of Stock Portfolio (o)

BP = Current Betya of the stock portfolio (1,25)

Vp = Value of stock Portfolio = $185 million

V F = Value of the stock index futures contract. (370 000)

185 00000 0
=(0-1,25) x
370000

= - 625 You must not sell 625 futures contracts. Negative you must sell.
Positive you must buy.

Thus the manager can establish an effective short hedge by going short 625 S &P, Index
fuctorus contract.
 - This short hedge will protect the stock portfolio of a general fall in the stock market
during thje remaining 3 months life of the Futures contract.

QUESTION

How many stock Index Futures contracts are required to hedge a $250million stock portfolio
assuming a portfolio Beta of 0,75 and S &P Index Futures level of 1500.

Current value of a single S &P500 Index Futures is:

(250x1500) = 375 000

250 00 0 000
No. of contracts = (0 – 0,75) x
375 000

= - 500. This short 500 futurs contracts (sell)

4(ii)

QUESTION

BBH is a US nenghomorati. US Pension Fund generates market forecast internally and

receives forecasts from independent consultants. As a result of the forecasts, BBH expect the
market for large Cap stocks to be stronger than it believes everyone in the market is expecting
over the next 2 months.

Action: BBH decides to adjust the Beta on $ 38 500 000 of large stocks from its current
current l to 1,10 for the period of the new 2 months. It has selected a Futures contract deemed
to have sufficient liquidity. The Futuns contract deemed to have sufficient liquidity. The The
Fuctons price is currently $ 275 000 and thye contract has a Beta of 0, 95. The approximate
number of Futurs contracts to adjust the Beta would be

N = ( B D−B P ) ( VP
VF )

= (1,10 – 0,9) ( 3805000 000

275 000 )
 = 28 They have to buy 28 futurs contracts. (Positive answer = Buy)

N ( BDBF−BP ) ( VP
VF )

To completely eliminate market to Zero

= ( 1,10−0 ,9 38 500 000

0 , 95 ) ( 275 000 )

=29 Futures contracts Scenario (December 3)

The market as a whole increases by 4,4 %

The stock portfolio increases to 40 103 000

The stock index Futures contract rises to $ 286 687,50 an increase of 4,25%

Outcome and analysis

- The profit on the futures contract is:

- - 29 Futures contracts (286 687,50 – 275 000)

=$338 937,50

The rate of return for the portfolio is

40 103 000
(38 500 000 )−1=4,16 %

- Add profit from Futures contract to the current stock portfolio’s value

40 103 000 +338 937,50 = $ 40 441 937, 50

- ( 40384419 37,50
500 000 )
-1 = 5,04%

0 , 0504
- Effective Beta = =1,15
0 , 044