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Futures Markets

Futures Markets. History- Fares in the Middle Ages Chicago Board of Trade (1848) (www.CBT.com) Forward Mkts vs. Futures Mkts. - a futures contract is a standardized forward contract. - grade, place & time of delivery,quantity are all standardized in a futures contract.

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Futures Markets

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  1. Futures Markets History- Fares in the Middle Ages Chicago Board of Trade (1848) (www.CBT.com) Forward Mkts vs. Futures Mkts. - a futures contract is a standardized forward contract. - grade, place & time of delivery,quantity are all standardized in a futures contract

  2. Corn Futures Example • Trading Unit - 5,000 bu • Deliverable Grades : No. 2 Yellow • Price Quote: Cents and quarter-cents/bu • Tick Size 1/4 cent/bu ($12.50/contract) • Contract Months : Nov, Dec, Jan, Mar, May, Jul, Sep • Ticker Symbol: C

  3. Futures Quote

  4. Futures Markets (Terms) • Settle Price • Open Interest • Futures Positions • Long (buy a contract) • Short (sell a contract)

  5. Kinds of Futures Contracts • Agricultural: Corn, wheat, etc. • Commodity: Oil, Gold, etc. • Currency: British Pound, etc. • Interest Rate: T-Bills, T-Bonds, etc. • Stock Index: S&P 500, DJ Index, etc. Futures Exchanges • Chicago Board of Trade (CBOT) • Chicage Mercantile Exhange (CME)

  6. Margin Positions - Every Exchange sets specific margin requirements for each contract of its traders. Margins: Customer margins are amounts that individual buyers and sellers of futures contracts are required to deposit with brokers. Margins are determinted on the basis of market risk and contract value.

  7. Margins and Marking to Market CBOT Corn Contract: 5,000 bu Initial Margin per contract: $473 Maintenance Margin: $350 Buy 1 Contract @ 300/cents per bu. Contract Value = 5,000 * $3 = $15,000 Initial Margin = $475 Leverage = 96.8%

  8. Marking to Market Example Day Price Value* Equity Margin Excess 1 $3.00 $15,000 $475 $475 $ - 2 $ 3.02 $15,100 $575 $350 $225 3 $ 2.99 $14,950 $425 $350 $ 75 4 $ 2.95 $14,750 $225 $350 ($125)** *Contract Value = Price * 15,000 bu **Deposit Margin Call $125 $350

  9. Futures Market Participants • Speculators • Hedgers Uses of Futures (hedging examples) • Farmer is long in commodity. • Lock in the price with a short position • If P rises, farmer gains, but short position loses • If P falls, farmer loses, but short position gains.

  10. Merchant is short in the commodity • Lock in the price with a long position • If P rises, merchant loses, but long position gains • If P falls, merchant gains, but long position loses. • Corportation wants to guarantee the cost of funds on a loan in the future. • Corp. is long on debt, i.e., it expects to sell debt in the future and fears the price will fall (rates will rise). • Corp. should take a short position in debt.

  11. S&L wants to make a long-term loan to a developer, financed by short-term CDs. • Once the loan is made, the S&L is long on debt because it must sell it in the future. It can hedge by going short on debt in the futures market. • U.S. Corp is planning to invest in the U.K. next year. It is short Pounds, because it must buy them next year. It can hedge by buying a futures contract today (taking a long position in Pounds).

  12. Stock Portfolio Manager fears a fall in the stock market, but for tax reasons does not want to sell. The fund manager is long on stocks. He can hedge his position by taking a short position (selling) stock index futures. • Pricing Stock Index Futures Program Trading (or Index Arbitrage) is another use of futures. When futures mature then: Pf = PS

  13. But prior to expiration, Pf > PS or Pf < PS If, however, (Pf - PS) / PS > kRF then traders will arbitrage between the two markets. • If Pf > PS , they sell futures and buy the spot. • If Pf < PS , they buy futures and sell the spot. In either case, they will earn a risk-free return greater than kRF .

  14. Program Trading Example: • Suppose S&P 500 futures is at 1,435 with 90 day to expiration. • At the same, the spot price of the S&P 500 is 1,400 • Then: (1,435-1,400)/1,400 = 0.025 and 0.025 * (360/90) = 10% > kRF • In this case, the trader would sell futures and buy the spot market. At expiration, when Pf = PS, the trader would reverse.

  15. Net Worth Hedging A bank can use futures to protect its balance sheet against changes in interest rates Suppose: Assets = 1,000,000 with Duration = 5 Liab. = 950,000 with Duration = 3 Duration of Assets > Duration of Liabilities If rates fall, equity rises, but if rates rise, equity falls

  16. This bank is exposed to interest rate risk. It can sell (go short) in interest rate futures to eliminate its risk. If it sells futures, then when rates rise it makes a profit in the futures market. Duration Rule (page 346) DG = MVA* DA - [MVL* DL + MVF* DF] If DG > 0, then bank gains when rates fall. If DG < 0, then bank loses when rates fall. If DG = 0, then bank is hedged against rate changes.

  17. Relation of Spot & Futures Prices • The futures price (Pf) can’t exceed the spot price (PS) by any more than the cost of carry (c) • Pf – PS <= c • Implied Cost of Carry = c = r + s • Pf = PS (1 + r + s) If you are willing to assume r you can compute s.

  18. Risks in Using Futures • Basis Risk - the futures contract may not move in perfect accord with what is being hedged. • Margin Risk - when a futures position moves against you, you must put up margin dollars.

  19. Homework Problems: 11-11, 11-12, 11-14

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