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Chapter 14
Futures Contracts
Slides
14-1. Chapter 14
14-2. Futures Contracts
14-3. Learning Objectives
14-4. Futures Contracts
14-5. Forward Contract Basics, I.
14-6. Forward Contract Basics, II.
14-7. Futures Contract Basics, I.
14-8. Futures Contract Basics, II.
14-9. Organized Futures Exchanges
14-10. Financial Futures
14-11. Futures Contracts Basics
14-12. Futures Prices in the Wall Street Journal
14-13. Futures Prices in the Wall Street Journal, Cont.
14-14. Futures Prices on the Web (www.cmegroup.com)
14-15. Why Futures?
14-16. Speculating with Futures, Long
14-17. Example I: Speculating in Gold Futures
14-18. Speculating with Futures, Short
14-19. Example II: Speculating in Gold Futures
14-20. Hedging with Futures
14-21. Hedging with Futures, Short Hedge
14-22. Example: Short Hedging with Futures Contracts
14-23. Example: Short Hedging with Futures Contracts, Cont.
14-24. The Short Hedge Performance
14-25. Hedging with Futures, Long Hedge
14-26. Example: Long Hedging with Futures Contracts
14-27. Example: Long Hedging with Futures Contracts, Cont.
14-28. The Long Hedge Performance
14-29. Futures Trading Accounts
14-30. Important Aspects of Futures Trading Accounts
14-31. Futures Trading Accounts, Cont.
14-32. Example: Margin and Marking to Market
14-33. Molly’s Trading Account for a Long Position in One Gold Futures Contract
14-34. Cash Prices
14-35. Quoted Cash Prices
14-36. Cash-Futures Arbitrage
14-37. Cash-Futures Arbitrage, Cont.
14-38. Spot-Futures Parity
14-39. Spot Futures Parity with Dividends
14-40. Stock Index Futures
14-41. Index Arbitrage
14-42. Cross-Hedging
14-43. Hedging Stock Portfolios with Stock Index Futures
14-44. Example: Hedging a Portfolio with Stock Index Futures
14-45. Another Portfolio to Cross-Hedge
14-46. Hedging Bond Portfolios with T-note Futures
14-47. Handy Estimate for the Duration of an Interest Rate Futures Contract
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Futures Contracts 14-2
14-48. Example: Hedging a Bond Portfolio with T-note Futures
14-49. Futures Contract Delivery Options
14-50. Useful Websites
14-51. Chapter Review, I.
14-52. Chapter Review, II.
Chapter Organization
14.1 Futures Contracts Basics
A. Modern History of Futures Trading
B. Futures Contract Features
C. Futures Prices
14.2 Why Futures?
A. Speculating with Futures
B. Hedging with Futures
14.3 Futures Trading Accounts
14.4 Cash Prices versus Futures Prices
A. Cash Prices
B. Cash-Futures Arbitrage
C. Spot-Futures Parity
D. More on Spot-Futures Parity
14.5 Stock Index Futures
A. Basics of Stock Index Futures
B. Index Arbitrage
C. Hedging Stock Market Risk with Futures
D. Hedging Interest Rate Risk with Futures
E. Futures Contract Delivery Options
14.6 Summary and Conclusions
Selected Web Sites
Futures Exchanges:
www.cmegroup.com
www.theice.com
www.tfx.co.jp/en (Tokyo Financial Exchange)
www.commodityhq.com (see reference section for a list of the world’s
largest commodity exchanges)
For Futures Prices and Price Charts:
futures.tradingcharts.com
www.barchart.com
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Futures Contracts 14-3
To Learn More about Futures:
www.usafutures.com
www.tradingmarkets.com (Trading Markets)
To Learn About Single-Stock Futures:
www.onechicago.com
Other Links:
www.investorlinks.com (for a list of futures brokers)
www.programtrading.com (for information on program trading)
www.cftc.gov (for information on futures markets regulation)
www.nfa.futures.org (National Futures Association)
www.futuresindustry.org (Futures Industry Association)
Annotated Chapter Outline
14.1 Futures Contracts Basics
Forward Contract: Agreement between a buyer and a seller, who both
commit to a transaction at a future date at a price set by negotiation today.
Futures Contract: Contract between a seller and a buyer specifying a
commodity or financial instrument to be delivered and paid for at a set
price at contract maturity. Futures contracts are managed through an
organized futures exchange. Exchange trading increases liquidity and
reduces counterparty risk, but it eliminates some flexibility associated with
being able to set an exact contract size.
Futures Price: Price negotiated by buyer and seller at which the
underlying commodity or financial instrument will be delivered and paid for
to fulfill the obligations of a futures contract.
While a forward contract can be struck between any two parties, a futures
contract must be managed through an organized futures exchange.
A. Modern History of Futures Trading
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Futures Contracts 14-4
Futures trading dates back to 17th century Japan, where rice futures were traded.
The CBOT is the oldest U.S. exchange, established in 1848. In 2007 it merged
with the Chicago Mercantile Exchange (CME), who bought the CBOT for about
$8 billion. The merged firm is called the CME Group. Then, in 2008, the CME
group acquired the New York Mercantile Exchange (NYMEX).
Only commodity futures were traded for over 100 years, until financial futures
appeared in the 1970s. The first were currency contracts, followed by interest
rate futures, and then stock index futures. Financial futures now constitute the
bulk of all futures trading.
B. Futures Contract Features
Futures contracts are derivative securities and are a zero-sum game. Futures
contracts must stipulate the following five contract terms:
The identity of the underlying commodity or financial instrument.
The futures contract size.
The futures maturity date, also called the expiration date.
The delivery or settlement procedure.
The futures price.
Specific delivery procedures are set by the futures exchange and may vary, but
normally the delivery procedures are selected for convenience and low cost.
C. Futures Prices
The largest volume of futures trading in the U.S. takes place in Chicago;
however, futures trading is also quite active at futures exchanges in New York,
Kansas City, and Minneapolis. Four of the five contract terms are specified in the
standard futures price listing provided in Figure 14-1: identity of commodity or
financial instrument, contract size, maturity date, and futures price.
14.2 Why Futures?
Futures contracts are used for hedging and speculation. Hedgers transfer price
risk to speculators, while speculators absorb price risk. Hedging and speculation
are complimentary activities.
A. Speculating with Futures
Long Position: In futures jargon, refers to the contract buyer. A long
position profits from a futures price increase.
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Futures Contracts 14-5
Short Position: In futures jargon, refers to the seller. A short position
profits from a futures price decrease.
Speculator: Trader who accepts price risk by going long or short to bet on
the future direction of prices.
If you think the price of a commodity or financial instrument is priced too low
relative to what they will be in the future, then you can speculate by buying the
futures. If you think it is priced too high, then you can speculate by selling the
futures. A speculator accepts price risk in order to bet on the direction of prices
by going long or short.
B. Hedging with Futures
Hedger: Trader who seeks to transfer price risk by taking a futures
position opposite to an existing position in the underlying commodity or
financial instrument.
Underlying asset: The commodity or financial instrument on which the
futures contract is based.
Short Hedge: Sale of futures to offset potential losses from falling prices.
Full Hedge: A futures position that is equal, but opposite, the position in
the underlying asset.
Long Hedge: Adding a long futures position to a short position in the
underlying asset.
As a hedger, one seeks to transfer price risk by taking a futures position opposite
to an existing position in the underlying commodity or financial instrument. If you
are long in the underlying commodity (because you own it), then you offset the
risk in your long position with a short position in futures. If prices rise, you have a
gain on the underlying commodity and a loss in the futures position. If prices
decrease, you have a loss in the underlying commodity and a gain in the futures
position. The gains and losses offset each other, and you have greatly reduced or
eliminated the possibility of a loss in the underlying commodity position. The
trade-off is that if prices rise, you have given up the gain in the commodity by
taking a loss in futures. This is an example of a short hedge.
If you do not own the underlying commodity, but need to acquire it in the future,
you can lock in the price you will pay in the future by buying the futures contract.
You are short the underlying commodity because you must buy it in the future, so
you offset the short position with a long position in futures. This is an example of
a long hedge.
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Futures Contracts 14-6
14.3 Futures Trading Accounts
Futures Margin: Deposit of funds in a futures trading account dedicated
to covering potential losses from an outstanding futures position.
Initial Margin: Amount required when a futures contract is first bought or
sold. Initial margin varies with the type and size of a contract, but it is the
same for long and short futures positions. It is generally in the 5 to 15
percent range.
Marking-to-Market: In futures trading accounts, the process whereby
gains and losses on outstanding futures positions are recognized on a
daily basis.
Maintenance Margin: The minimum margin level required in a futures
trading account at all times.
Margin Call: Notification to increase the margin level in a trading account.
Reverse Trade: A trade that closes out a previously established futures
position by taking the opposite position.
A futures exchange allows only exchange members to trade on the exchange.
Members may be firms, or individuals trading for their own accounts, or they may
be brokerage firms handling trades for customers. The three essential things to
know about a futures trading account are:
Margin is required.
Futures accounts are marked-to-market daily.
A futures position can be closed out any time by a reverse trade.
14.4 Cash Prices versus Futures Prices
A. Cash Prices
Cash Price: Price of a commodity or financial instrument for current
delivery. Also called the spot price.
Cash Market: Market in which commodities or financial instruments are
traded for essentially immediate delivery. Also called the spot market.
B. Cash-Futures Arbitrage
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Futures Contracts 14-7
Cash-Futures Arbitrage: Strategy for earning risk-free profits from an
unusually large difference between cash and futures prices.
Basis: The difference between the cash price and the futures price for a
commodity, i.e., basis = cash price - futures price.
Carrying-Charge Market: The case where the futures price is greater
than the cash price, i.e., the basis is negative. This is referred to as
contango.
Inverted Market: An inverted market is one where the futures price is less
than the cash price, i.e., the basis is positive. This is also referred to as
backwardation.
Earning risk-free profits from an unusual difference between cash and futures
prices is called cash-futures arbitrage. In a competitive market, cash-futures
arbitrage yields very slim profits, if any at all. The difference between the cash
price and the futures price is the basis. There are several economic factors that
justify the basis, including storage costs, transportation costs, and seasonal price
fluctuations.
C. Spot-Futures Parity
Spot-Futures Parity: The relationship between spot prices and futures
prices that holds in the absence of arbitrage opportunities.
The futures price is simply the future value of the spot price, compounded at the
risk-free rate. It is shown as:
F = S(1 + r)T
D. More on Spot-Futures Parity
The previous spot-futures parity assumed no dividends. If we include dividends
and denote the dividend yield by d, we have:
F = S(1 + r - d)T
14.5 Stock Index Futures
A. Basics of Stock Index Futures
The buyer of a stock index futures contract has agreed to purchase the index at
the futures price, and the seller has agreed to sell the index at the futures price.
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Futures Contracts 14-8
The futures price is normally 100 times the index, although the S&P 500 is 250
times the index. If the price rises, the buyer profits from the increase, and the
seller loses money. If the price goes down, the reverse occurs.
A. Index Arbitrage
Index Arbitrage: This is a strategy that involves monitoring the futures
price on a stock index and the level of the underlying index to exploit
deviations from spot-futures parity.
Program Trading: Computer-assisted monitoring of relative prices of
financial assets; it sometimes includes computer submission of buy and
sell orders to exploit perceived arbitrage opportunities.
Spot-futures parity is the basis for index arbitrage—monitoring the futures price
on a stock index along with the level of the underlying index. The trader attempts
to take advantage of violations of parity. If the trader sees the futures price is too
low, he/she sells the index and buys the futures contract.
Many times program trading is used to take advantage of index arbitrage.
Computers are used to spot the arbitrage opportunities, and then computers
again quickly submit the buy and sell orders. Program trading sometimes
accounts for over half of total volume on the NYSE. The NYSE defines program
trading as the simultaneous purchase or sale of at least 15 stocks with a total
value of $1 million or more.
Related to index arbitrage and futures and options trading is the triple witching
hour. This is when S&P 500 futures contracts, options on the S&P index, and
various stock options all expire at the same time, which occurs four months a
year on the third Friday of the month. Since all three types of contracts expire at
the same time, unusual price behavior sometimes occurs. Enormous buying and
selling occur as large positions are closed out due to large-scale index arbitrage
and program trading. Large price swings and increased volatility are common, so
several exchange rules have been adopted to control this problem.
B. Hedging Stock Market Risk with Futures
Cross-Hedge: Hedging a particular spot position with futures contracts on
a related—but not identical—commodity or financial instrument.
A portfolio manager may want to protect the value of a portfolio from the risk of
an adverse movement of the market. To do this the manager would establish a
short hedge using futures to protect the portfolio against a fall in prices during the
life of the futures contract. There are four basic inputs required to calculate the
number of stock index futures contracts needed to hedge a stock portfolio:
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Futures Contracts 14-9
The current value of your stock portfolio, say $200,000,000.
The beta of your stock portfolio, say 1.45.
The contract value of the index futures contract used for hedging, 250
times the index level of, say, 2,050.
The beta of the futures contract.
oIf the futures contract is for the same index as used to calculate
the stock beta, then the futures contract beta is one. This is
generally the case.
To calculate (remember to use the S&P 500 index multiplier of 250):
If the beta was 1.15 instead, the hedger would need to short about 449 contracts.
C. Hedging Interest Rate Risk with Futures
Hedging a bond portfolio is similar to a stock portfolio, but the goal is to protect
against changing interest rates. To protect against rising interest rates (and a fall
in the value of the bond portfolio), establish a short hedge in futures. The formula
is:
To estimate the duration of the futures contract:
Example: You want to protect the value of a $100,000,000 bond portfolio over the
near term (so, you will “short-hedge”). The duration of this bond portfolio is 8.
Suppose the duration of the underlying T-note is 6.5, and the futures contract has
0.5 years to expiration. Also suppose the T-note futures price is 98 (which is 98%
of the $100,000 par value).
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Number of contracts =βP×VP
βF× VF
566≈1. 45×$200,000,000
1 × 250×2,050
No.of contracts=DPx V P
DFx V F
DF=DU+MF
Number of contracts needed =DP×VP
DF×VF
1,166≈8×$100,000,000
(6 . 5+0.5)×(0 .98×$100,000 )
Futures Contracts 14-10
If three-month futures are used instead of 6 month futures, the hedger will need
to short about 1,209 contracts. The only difference becomes that 0.25 is added to
6.5 in the formula, rather than 0.50.
D. Futures Contract Delivery Options
Cheapest-to-Deliver Option: Seller's option to deliver the cheapest
instrument when a futures contract allows several instruments for delivery.
For example, U.S. Treasury note futures allow delivery of any Treasury
note with a maturity between 6½ and 10 years.
Many futures contracts have a delivery option whereby the seller can choose
among several different grades of the underlying commodity or instrument when
fulfilling delivery requirements. The “cheapest to deliver option,” or quality option,
allows the seller to deliver the cheapest instrument among the specified
alternatives. A hedge will have to be monitored regularly to ensure it reflects the
issue most likely to be delivered.
14.6 Summary and Conclusions
Lecture Tip: Like options, futures contracts is a topic that tends to greatly
interest students. The Stock-Trak exercises are one way to allow students to
trade futures and become more familiar with their characteristics. Another project
is to have students select a futures contract in each of three areas: commodity,
stock indexes, and interest rates. Have them predict the direction of pricing for
each of these futures and buy and/or sell the futures contract, speculating on the
direction of the price movements.
Alternatively, the instructor sets up initial stock and bond portfolios. Then, the
students are required to set up a hedge, using futures contracts for each of the
portfolios. This should be done early enough in the semester so that the students
can track the progress of their hedge on the changing value of the portfolios. This
will give them a "real-life" example of how difficult actual hedging can be.
There is a great deal of information available on-line concerning futures markets.
The U.S. exchanges (CME, NYMEX, etc.) have especially information-packed
websites.
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