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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.
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.
Chapter 17 - Futures Markets and Risk Management
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
2. Trading Mechanics
PPT 17-6 through PPT 17-10
Trades can be closed out by taking or making delivery or by reversing the trade. Most trades are
closed out by reversing the trade and not by taking or making delivery. Futures trading involves
a clearinghouse that acts similarly to the Options Clearing Corporation (OCC) from the prior
chapter. The clearinghouse eliminates counterparty default risk; this allows anonymous trading
Margin arrangements on futures differ from margin arrangements on stock. The initial margin
on 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
Chapter 17 - Futures Markets and Risk Management
On Monday morning you sell one T-bond futures contract at 97-27 (97 27/32% of the $100,000
face value). Futures contract price is thus $97,843.75. The initial margin requirement is $2,700
and the maintenance margin requirement is $2,000. Margin requirements are available from the
CME. The sizes of the margin requirements are chosen based on daily volatility to limit the
DAY
SETTLE
$ VALUE
PRICE
CHANGE
MARGIN
ACCOUNT
TOTAL
%HPR
(CUM.)
SPOT
HPR
(CUM.)
Open
$9,7843.75
$2700
Mon.
97-13
$97,406.25
-$437.50
$3137.50
-16.2%
-0.45%
The settlement prices are in dollars and 32nds. The settlement price is determined by an
exchange committee at the end of each day’s trading. Usually it will be the last trade price,
although it may vary slightly depending on the volume of trades around the closing. The
translated dollar value is in column (3). The price change, column (4) is the new price minus the
The spot HPR (cum) is the percent change in the $ value column, keeping the Monday open as
Why Delivery on Futures is Not an Issue:
You go long on T-Bond futures at Futures0 = $110,000. Suppose that at contract expiration,
SpotT-Bonds = $108,000. With daily marking to market, one has already given seller $2,000 in
total so if one takes delivery one only owes $108,000. The invoice is adjusted by the net daily
marking to market. One is prepaying/earning any gains or losses each day. With no delivery
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
price to fall, a short position is taken. The investor sells the asset at the high price and reverses
4. The Determination of Futures Prices
PPT 17-14 through PPT 17-18
Chapter 17 - Futures Markets and Risk Management
Pricing on futures contracts is described using the spot-futures parity theorem. The theorem is
based on the concept that there are two ways to acquire an asset for use in the future. First, the
Action
Initial Cash
Flow
Cash Flow at T
1. Borrow S0
S0
-S0(1+rf)T
In the text example, a few assumptions should be made explicit. First, the only cost of carry in
this example is the time value of money represented by the risk free rate, so ignore any physical
storage cost of the commodity which would normally have to be added. Borrowing the money to
buy the spot commodity, buying the spot and concurrently short the futures is riskless because
5. Financial Futures
PPT 17-19 through PPT 17-27
Chapter 17 - Futures Markets and Risk Management
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
strategies and also hedging strategies. An investor that is fearful of a market decline could short
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 available for major currencies at the CME, the LIFFE and others, but only with
6. Swaps
PPT 17-28 through PPT 17-39
One of the markets that have experienced phenomenal growth is the swap market. Swaps are
basically groups of forwards that are packaged together. They allow participants in the market to
hedge exposures over longer periods than futures contracts. Many swap agreements extend
beyond 5 years. This makes swaps one of the best means to hedge long term exposures. In
interest rate swaps one party agrees to pay the counterparty a fixed rate of interest in exchange
for paying a variable rate of interest or vice versa; no principal is exchanged. Variations are
Chapter 17 - Futures Markets and Risk Management
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%.
Swap dealer agrees to both
deals, manages net risk.
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,
Currency swaps are contracts where two parties agree to swap principal and interest payments at
a fixed exchange rate. These contracts allow firms to borrow money in whatever currency has a
lower interest rate and then swap payments into the currency they prefer. In 2009 there were
Excel Applications
There is an excel application on the web site that allows students to examine spot futures parity
and time spreads with different futures contracts.
