Professional Documents
Culture Documents
Chapter 2 Futures
Chapter 2 Futures
Chapter 2 Futures
Futures Markets
Rangarajan K. Sundaram
2
Outline
Introduction
Futures Pricing
3
Introduction
4
Objectives
5
The Origins
6
The 19th Century
7
Three Major Trends
Consolidation A worldwide phenomenon.
NYMEX-COMEX (1994); CME-CBoT (2007);CME-NYMEX (2008).
Creation of Eurex, Euronext; Euronext-LIFFE (2002);NYSE-Euronext
(2007).
In emerging markets too: e.g., BM&FBovespa (2008).
Increasing role of financial futures.
Until the 1970's: asset underlying futures was a commodity (e.g.,
wheat, gold, oil).
In 1972, first financial futures (currency futures) were introduced
at the CME.
Interest-rate futures followed in mid 70's, and stock-index futures
in early 80's.
Increasing role of technology: the trading "pit" is dying out.
8
Volume of Trading on CBoT
9
The Top 15 Futures Contracts Worldwide: 2008
10
Standardized Contract Terms
11
Standardization
12
Example: Commodity Futures Contracts
13
Example: Financial Futures Contracts
14
Example: "Mini" Futures Contracts
15
Example: The Corn Futures Contract
16
Example: The Yen Futures Contract
17
Example: The T-Bond Futures Contract
Exchange: CBoT.
Contract months: March, June, September, December.
Size: $100,000 in face value of US Treasury Bonds.
Quality:
Coupon of 6%.
Must have at least 15 years to maturity or first call.
Delivery options:
Any other coupon can be delivered.
Cash flows from delivered bond will be discounted at 6% rate to obtain
conversion factor for price adjustment.
18
Conversion Factor: An Example
So long position (buyer) will pay the short position (seller) 1.2311 times
the agreed-upon delivery price.
Remember:
19
Consequences of Delivery Options
20
Unilateral Reversal of Positions
21
Reversal of Positions
22
Reversal of Positions
23
Why Allow Reversal?
24
An Example
A US firm will receive £20 million on February 28, and wants to hedge
against changes in the $/£ exchange rate using March futures contracts.
Current futures delivery price for March delivery: $1.64/£.
Consider the following strategy:
Take a short (sell) position in the March futures contract with the
delivery price of $1.64/£.
On February 28, close out the short (sell) futures position by taking
a long (buy) futures position.
Sell the £20 million in the spot market on February 28.
25
Convergence of Futures to Spot
26
Quick Review of Futures Markets:
https://www.youtube.com/
watch?v=CC9VeHrI3Es
Default Risk and Margin Accounts
https://www.youtube.com/wa
tch?v=Njy9wm4dOZc
27
Margin Accounts
Since buyers and sellers do not interact directly, there is an incentive for
either party to default if prices move adversely.
To inhibit default, futures exchanges use margin accounts.
This is effectively the posting of collateral against default.
The level at which margins are set is crucial for liquidity. Too high levels
eliminate default, but inhibit market participation. Too low levels increase
default risk.
In practice, margin levels are not set very high.
28
The Margining Procedure
Initial margin.
Marking-to-market.
Maintenence margin.
29
Margining: An Example
Suppose that
30
Example: Marking-to-Market
31
Example: Marking-to-Market
"Loss" per contract: $(17, 900 — 17, 700) = $200 per contract.
Total loss = $2,000; debited from the margin account.
New margin account balance: $5,780.
32
Margining: Summary
33
Margin Levels: Examples
34
Futures Pricing
35
Futures vs. Forward Prices
36
Case Study: The GNMA CDR
Futures Contract
37
Case Study: GNMA Futures
38
GNMA CDR Futures: Trading Volumes
39
Hedging Spot Risk: The Role of Correlation
40
Hedging Demand in Mortgages
41
The Role of Delivery Options
Futures contracts also have delivery options that provide for alternative
deliverable grades and the price adjustments for each grade.
The actual delivered grade will be not the standard grade, but the
cheapest-to-deliver grade.
This means the futures price will always bear a close relationship to the price
of the cheapest-to-deliver grade.
However, we want the futures price to be closely related to the price of
current-coupon mortgages.
Conclusion:
The delivery options must be specified such that the current coupon
mortgages are typically the cheapest-to-deliver.
42
The GNMA Contract Specification
43
The Problem
44
To Summarize ...
For the contract to be a good hedge, the futures price must be closely
related to the price of current-coupon mortgages.
In general, for any futures contract, the futures price is closely related to
the price of the cheapest-to-deliver grade.
Thus, the delivery options must be such that current coupons are closely
related to the cheapest-to-deliver prices.
However, the specification of the delivery options in the GNMA CDR
futures contract makes high-coupon mortgages typically the cheapest-to-
deliver grade.
45
The Consequence ...
Thus, as long as high coupons are also current coupons (i.e., interest
rates are constant or rising), the contract will be a good hedge.
This was actually the case between 1975 and 1982.
Coupon rates were around 8% in 1975, rose to 17% in late 1981, and
remained at 16–17% until early 1982.
As a consequence, trading in the contract grew rapidly.
However, in late 1982, interest rates declined steeply.
The contract was no longer a useful hedge vehicle.
Trading in the contract dropped to near-zero levels by 1987.
Interest in the contract never revived as Treasury futures and other
contracts supplanted it as the hedge vehicles of choice.
46
Case Study: Metallgesellschaft AG
47
Case Study: Metallgesellschaft
48
The Need to Hedge
49
In Principle ...
50
Between Cup and Lip ...
51
A Background Factor
One factor that robbed MGRM of its anonymity was the sheer size of the
positions involved.
Position limits made it impossible to completely hedge MGRM's total
commitments of 160 million barrels using only futures contracts.
MGRM had long futures positions of 55 million barrels on NYMEX.
It also entered into OTC swaps arrangements to hedge the remaining
exposure.
52
A Fall in Oil Prices
Every $1 fall in oil prices would lead to a $55 million cash outflow on the
futures margin accounts alone.
A steep oil price fall would thus create an immediate and large cash
requirement to meet margin calls.
The corresponding gains on the short forward positions would not
translate into cash inflows until some date in the future.
Thus, although the economic value of the position is unaffected (it
remains hedged), a severe short-term cash flow requirement is created.
53
Nightmare Scenario No. 1
Unfortunately for MGRM, this scenario came true: oil prices plummeted in
late 1993.
This led to a cash requirement of around $900 million to meet margin
calls (on the futures positions) and extra collateral (on the OTC positions).
54
Oil Prices in 1993-94
55
Backwardation to Contango
56
The Problem with Contango
57
Nightmare Scenario No. 2
Through much of the mid and late 1980's, the oil futures market was in
backwardation.
If this situation had continued, MGRM could have expected to make large
profits on rollover.
Unfortunately for MGRM, in late 1993, the oil market went into contango.
As a consequence, by end-1993, MGRM was incurring a cash outflow of up
$30 million each month on rollover costs alone.
58
The Problem of Basis Risk
A final technical issue that may have hurt MGRM is basis risk.
MGRM was hedging long-term forwards with short-term futures.
Since these two prices may not move in lockstep, there is basis risk in hedging.
In the presence of basis risk, a well-developed theory shows that it is not, in
general, optimal to use a hedge ratio of unity (i.e., to hedge exposure one-for-
one).
However, MGRM does appear to have used a hedge ratio of unity which may
have further degraded the quality of the hedge, adding to losses.
59
The Denouement
60
Arguments in Favor
61
Arguments Against
62
Timing is Everything
63