FINANCE IN A CANADIAN

SETTING
Sixth Canadian Edition
Lusztig, Cleary, Schwab
CHAPTER TWENTY

Futures
 Learning Objectives
1. Explain how futures contracts differ from options.
2. Discuss the difference between futures contracts
and forward contracts.
3. Define the terms backwardation and forwardation.
4. Explain arbitrage and demonstrate how it works in
commodity and financial futures.
5. Describe how different types of futures (foreign
currency, interest rate, stock index, etc.) contribute
to risk management.
 Introduction
Physical commodities and financial instruments
are traded in cash markets
Two types of cash markets:
spot markets feature immediate delivery

forward markets have deferred delivery

A way to mitigate risk is through:

Forward contracts a negotiated agreement

between a buyer and a seller to lock in a price

at which a future transaction will occur
 Introduction
Who uses forward contracts?
oil production and refinery companies

mining companies

An alternative way of locking in future prices is

through:
Futures contracts agreements to trade a specified

asset at a specified price and time in the future

Characteristics of futures contracts include:
contracts are standardized
they trade on futures markets

they are contracts with a futures market clearing house

 Basic Concepts
Conceptually, forward or futures contracts can
be written on anything, including oil, grains,
metals, weather, currencies, and interest rates
Futures contracts can be divided into two broad
categories:
1. commodities agricultural, metal, and
energy-related products
2. financials foreign currencies, debt and
equity instruments
 Basic Concepts
Commodity futures contract when the underlying
asset is a real commodity
Financial futures contracts when the underlying
asset is a financial obligation such as currency,
bond, or stock portfolios
Futures price is the price set out in a futures
contract
Settle price the price at which the markets books
were balanced at the end of the days trading
 Basic Concepts
Organized exchanges are crucial to the
usefulness of futures contracts as risk-
management tools
Futures trade on:

WCE, ME (Canada)

CME, NYCE, NYME, NYFE (US)

Futures contracts have maturities of less than

seven years
Futures contracts are standardized
 Options and Futures

Options give the owner the right to buy or

sell the underlying asset
Futures and forward contracts carry the
obligation to trade the underlying asset
Both options and futures are zero sum
investment
 Organization of
Futures Markets
Investors must establish a commodity or
margin account in order to trade futures
contracts
Margin requirements are between 5 and 10
percent of the value of the position
Futures markets are subject to daily limits on
price fluctuations
Investors in futures may also be subject to
position limits
 Marketing to Market

Marking to market the futures markets

elaborate system of daily adjustments of
contract prices and margin accounts
Neither party deals directly with each other
On futures exchanges, almost 90 percent of
all positions are closed out before they
mature
 Hedges and Speculators
Hedgers traders who open futures positions to manage
risk that arises from other businesses
hedgers:

are in the market to buy insurance

Speculators investors who open futures positions
expecting to close them again at more advantageous prices
speculators:

provide liquidity to the market and increase efficiency

are in the market to make money
 Commodity Futures Prices
The Expectations Hypothesis
states that future prices of a commodity should be what
traders expect the spot price to be in the future
The Net Hedging Hypothesis
Normal backwardation when a futures market has a
shortage of hedgers in long positions which means the futures
contract price will fall below the spot price expected in the
future (F E(S))
Normal forwardation a futures market with a shortage of
hedgers on the short side of the contract which causes the
future price to exceed the expected spot price (F > E(S))
Commodity Futures Prices

Commodity Futures Arbitrage

when futures contracts approach maturity
the futures price equals the spot price,
otherwise an arbitrage situation occurs

For assets that are not maturing,
arbitrageurs set limits on the difference
between the futures prices and the current
spot prices known as boundaries
Commodity Futures Prices
The boundaries formula is: F S(1 + r)t + ct
where:
F = future price
S = spot price
r = annual risk-free interest rate
t = time until maturity of the futures contract measured in
years
c = annual storage, insurance, transportation for carrying an
inventory of underlying assets
When the futures prices exceeds the upper limit there
is a arbitrage situation
 Financial Futures Prices

Foreign currency futures:

allow one to lock in an exchange rate at a
specified point in the future
are available in all major currencies
are valuable risk-management tools for firms
that engage in international business
Foreign currency exposure the term used
when a business has a net contractual
obligation in a foreign currency
 Financial Futures Prices
Interest rate forward and futures contracts allows one to
lock in a price at which a debt instrument is to be bought
or sold in the future
Interest rate futures should be considered when:
1. Borrowers want to protect against future interest rate
increases
2. Investors want to protect against future interest rate
decreases
3. Financial institutions are exposed to interest rate risk
4. Speculators want to bet on interest rates moving in a
particular direction
 Financial Futures Prices

Stock index futures:

allows one to lock in a future price at which
one can buy the portfolio of stocks that
make up a stock market index

are for specified amounts of underlying
assets

are settled in cash
 Financial Futures Prices

Program trading when institutions use

direct computer links to stock
exchanges to assemble large portfolios
of stocks that are based on theoretical
equivalence of positions
in index futures and their
underlying stocks
 Summary

1. Futures contracts and forward contracts are

devices for locking in prices for future
transactions. They commit the investor to
buying or selling in the future at that price.
There is no choice on whether or not to
exercise. Futures and forward contracts are
less flexible than options. Their compensating
benefit is that futures entail no up-front cost.
 Summary

2. Futures contracts are standardized agreements

with futures market clearing houses to buy or
sell assets at specified times and prices.
Commodity futures contracts are for important
agriculture products, metals, oil, and other
commodities. Financial futures contracts that
allow one to buy or sell foreign currencies, debt
instruments, and stock portfolios have become
important risk-management devices.
 Summary

3. If a commodity futures price is lower than

the spot price traders expect to see at the
time the futures contract matures, the market
for that futures contract is said to display
backwardation. If the futures price is higher
than the expected spot price, the market is
said to display forwardation.
 Summary

4. Commodity futures are set by the interaction

of the supply and demand for price hedging,
but are limited by an arbitrage constraint.
Futures contracts are important tools for risk
management. Commodity futures contracts
can be used to lock in prices for the firms
inputs and products and hedge against price
changes.
 Summary

5. Foreign currency futures can be used to lock

in exchange rates and limit foreign currency
risk. Interest rate futures lock in the prices
and yields of debt instruments, allowing firms
to hedge against the risk of interest rate
fluctuations. Stock index futures contracts
lock in the prices of stock portfolios based on
widely used stock indices.