Chapter 17 – Futures Markets and Risk Management
CHAPTER SEVENTEEN
FUTURES MARKETS AND RISK MANAGEMENT
CHAPTER OVERVIEW
This chapter describes the futures markets, trading mechanics involved with futures trading,
strategies and risks associated with futures trading and pricing of futures contracts. The material
covers background material on stock index contracts, describes how such contracts can be used
for hedging and speculation and discusses the concept of index arbitrage. Swaps are also briefly
covered.
LEARNING OBJECTIVES
After studying the chapter students should be able to describe basic characteristics of futures
contracts, understand short and long positions and profits from such positions, and margin trading
arrangements for futures. Students should be able to develop prices for stock index contracts and
describe how such contracts can be used to speculate and hedge. Students should also have a
basic understanding of interest rate swaps.
CHAPTER OUTLINE
1. The Futures Contract
PPT 17-2 through PPT 17-5
Basic elements of futures and forwards are described. Futures contracts are more standardized
than forwards. Performance on futures contracts is warranted by the clearinghouse. Performance
is not warranted on forward contracts. Futures contracts are marked to market and can be traded
on secondary markets. With a forward contract there is no active secondary market.
The futures price is the price that is agreed-upon for delivery at maturity. Long positions are
contracts in which the owner agrees to purchase the asset at maturity but the purchase price is
determined by the futures price at the time the contract is initiated. Short positions, or selling
futures, are a promise to deliver the underlying asset at contract maturity future delivery. A profit
graph of the gains and losses on futures and a call option are given below:
Chapter 17 – Futures Markets and Risk Management
The payoff function for the option is different because an option holder has the right to buy the
underlying asset but need not, whereas the long futures position is a commitment to buy the
underlying at the price F0 when the contract matures. A list of future contracts is provided below
broken up into the major categories.
There are several oil contracts available. Students may ask questions about oil speculation since
that has been in the news at times when oil prices rose over $100 a barrel. Speculators bore much
of the blame for this. This brings up the argument about whether speculation should be allowed in
futures and in spot markets. Hedging oil prices allows oil users to better predict their cost and
helps keep final costs of their products down. Futures markets allow price discovery and give
investors better information about expected future spot prices. The futures price is a biased
estimate of the expected future spot price. The reason for the bias is a risk premium and the risk
markets. Some fear that there is transference of volatility from the derivatives markets to the spot
markets. Evidence generally indicates that this is not true in normal markets but it probably does
happen in abnormal markets such as a panic; hence circuit breakers are employed in the stock
markets that break the link between the two markets.
2. Trading Mechanics
PPT 17-6 through PPT 17-10
17–2
Chapter 17 – Futures Markets and Risk Management
markets. Entering a futures contract is a commitment to buy or sell the underlying asset.
However, because the contract is liquid, over 90% of futures contracts do not result in delivery.
They are instead closed out with a reversing trade. The clearinghouse nets the investor’s position
to zero and no more changes are made to the investor’s margin account. An investor might worry
that they will forget and accidentally be forced to take or make delivery. It is common to have
futures is a deposit that is made to assure that the contracting party will fulfill the contract. The
profits and losses on the contract are realized on an immediate basis at the end of the day when
the futures prices is settled. The margin is basically prepaying the possible losses for the day.
When the margin falls to a predetermined level, the maintenance margin level, more margin is
required to keep the position open. If the investor can’t or won’t post the required margin, the
clearinghouse’s risk. The clearinghouse basically requires the participants to prepay potential
daily losses and then all the house does is transfer funds from the long to the short and vice versa.
Note that brokers may require higher margin accounts than the exchange mandated minimums
stated here. They typically will require higher minimums for retail accounts.
DAY SETTLE $ VALUE PRICE
MARGIN
TOTAL
SPOT
Wed. 100-00 $100,000.00 $2000.00 $543.75 -79.9% -2.2%
+$2156.25
$2700.00
17–3
in column (3). The price change, column (4) is the new price minus the old price. Column (5)
contains the effects on the margin account. Note that as the investor went short, a drop in price is
a gain and adds to the margin account whereas price increases are losses. The total %HPR is
found from as the cumulative (cum) percent change in the margin account column. For instance,
16.2% = (3137.50 – 2700)/2700, (the price fell so this is a gain to the short, who can ostensibly
5.8% = (2543.75 – 2700)/2700,
-79.9% = (543.75 – 2700)/2700
The spot HPR (cum) is the percent change in the $ value column, keeping the Monday open as
0.45% = (97,406.25 – 97,843.75)/97,843.75
-0.16% = (98,00.00 – 97,843,75)/97,843.75
-2.2% = (100,000.00 – 97,843.75)/97,843.75
The leverage multiplier can be found by taking the ratio of the futures return / Spot HPR return,
for example 16.2% / 0.45% ≈ 36.
Why Delivery on Futures is Not an Issue:
3. Futures Market Strategies
PPT 17-11 through PPT 17-13
Futures contracts can be used to speculate on price movements or to hedge against price
movements. A speculator is hoping to profit from a price change. If a speculator expects the
4. The Determination of Futures Prices
PPT 17-14 through PPT 17-18
Pricing on futures contracts is described using the spot–futures parity theorem. The theorem is
1. Borrow S0 S0-S0(1+rf)T
2. Buy spot for S0 -S0ST
3. Sell futures
short
0 F0 – ST
Total 0 F0 – S0(1+rf)T
In the text example, a few assumptions should be made explicit. First, the only cost of carry in
5. Financial Futures
PPT 17-19 through PPT 17-27
Stock index contracts have improved many trading and hedging strategies. Stock contracts are
available on a variety of domestic and international stock indexes. They offer considerable
advantages over direct stock purchases. The advantages of futures indexes apply to investment
via index arbitrage. This is a form of program trading. Sample contracts are presented in Text
Figure 17.2 which is replicated here (see below). Index contracts reduce the cost of a classic
market timing strategy involving switching between Treasury bills and stocks based on market
conditions. It is cheaper to buy Treasury bills and then shift stock market exposure by buying and
selling stock index futures. In this strategy the investor is changing the relative weights on the
Chapter 17 – Futures Markets and Risk Management
Foreign currency and interest rates are also available in the financial futures markets. The majority
of currency activity occurs off exchange with major banks acting as dealers in spot and forward
trading. Quotes from the dealer spot and forward markets are displayed. Futures contracts are
issuing the forward contract the bank may cancel the contract at the customer’s request.
Major contracts include contracts on Eurodollars, Treasury Bills, Treasury notes and Treasury
bonds. Contracts on some foreign interest rates are also available. A short position in these
contracts will benefit if interest rates increase and may be used to hedge a bond portfolio. A long
position benefits if interest rates fall. A bank that has short term loans funded by longer term debt
6. Swaps
PPT 17-28 through PPT 17-30
One of the markets that have experienced phenomenal growth is the swap market. From 2004 to
2007 the notional principal of interest rate swaps grew at 25% per year. Swaps are basically
groups of forwards that are packaged together. They allow participants in the market to hedge
Swaps are among the most flexible tools available and can serve a variety of purposes. In the
example below two institutions use swaps to limit their interest rate risk. If an institution has
variable rate or short term interest bearing assets funded by longer term fixed rate liabilities it is at
risk from falling interest rates. If an institution has fixed rate or long term interest bearing assets
funded by shorter term variable rate liabilities it is at risk from rising interest rates. Since an
Company A wants variable rate
financing to match their
variable rate investments.
They will pay LIBOR + 5 basis
points.
Company B wants fixed-
rate financing. They will
pay 7.05%.
Chapter 17 – Futures Markets and Risk Management
Recall that LIBOR is the London Interbank Offer Rate, the rate that banks charge each other in
the international banking market. Note that the swap dealer is not exposed to interest rate risk,
but they do face counterparty credit risk. The two deals may not be done synchronously, and
probably won’t be. The dealer (typically a bank) manages the ‘swap book.’ The variable side is
trillion notional principal in interest rate swaps outstanding. These numbers are from the BIS
(Bank of International Settlements) which collects data on all OTC derivatives and publishes a
triennial survey of market size. The $342 trillion (yes that is not a typo, its trillion) vastly
overstates the market size because interest rate swaps don’t involve principal exchanges. The
numbers for interest rate swaps include only single currency swaps, and the euro is now the