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Futures Markets. Riccardo Colacito. Motivational Example #1. A farmer grows wheat The entire planting season’s revenue depends on the highly volatile crop’s price Diversification is not possible The farmer would like to lock in a price at which deliver the crop. Motivational Example #2.
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Futures Markets Riccardo Colacito
Motivational Example #1 • A farmer grows wheat • The entire planting season’s revenue depends on the highly volatile crop’s price • Diversification is not possible • The farmer would like to lock in a price at which deliver the crop
Motivational Example #2 • A US firm is exporting part of its produced goods to the UK in a month • The goods will be paid in British Pounds and must then be converted in US Dollars • The exchange rate is quite volatile • The US firm would like to lock in an exchange rate
Forwards and Futures • Forward - an agreement calling for a future delivery of an asset at an agreed-upon price • Futures - similar to forward but feature formalized and standardized characteristics
Key difference in futures • Standardized types of contacts • Standardized contract units • Higher Liquidity • Marked to market • Clearinghouse warrants performance
Key Terms for Futures Contracts • Futures price - agreed-upon price at maturity • Long position - agrees to purchase • Short position - agrees to sell • At the time the contract is entered into, no money changes hands
Profits on positions at maturity • Long = spot minus original futures price • Short = original futures price minus spot • That is the long position profits from price increases!
Futures vs Options • The long futures position trader cannot simply walk away from the contract • No need to distinguish between gross payoff and net profit, • Because futures contract is not purchased: it is simply a contract that is agreed to by two parties
Figure 16-2 Profits to Buyers and Sellers of Futures and Options Contracts
Futures vs Options (cont’d) • Remember how the profit profile of an investor that buys a call option looks like? • How does it compare with the payoff of an investor holding a long futures position? • The answer on the set of slides `Options Markets’!
Types of Contracts • Agricultural commodities • Metals and minerals (including energy contracts) • Foreign currencies • Financial futures • Interest rate futures • Stock index futures • `Exotic futures’: www.tradesports.com
Trading Mechanics • Clearinghouse - acts as a party to all buyers and sellers. • Long and short traders do not hold contracts with each other • Clearinghouse acts as seller or buyer • Obligated to deliver or supply delivery • Only party that can be hurt by failure of any trader to respect obligation • Clearinghouse is neutral: it takes a long for each short position
Closing out positions • Almost all traders liquidate their positions before the contract maturity date • This is called reversing the trade • If a long position wants to close it before maturity, instructs broker to enter the short side of a contract • Profits or losses on the contract are realized • Less than 3% of contracts gets to maturity
Concept check • So: what’s the profit/loss realized by the long trader that buys a contract at time 0 and reverses it at time t? • What about the short trader?
Margin and Trading Arrangements • Initial Margin – funds (cash or T-Bills) deposited to provide capital to absorb losses • Initial Margin is usually between 5% and 15% • Marking to Market - each day the profits or losses from the new futures price and reflected in the account.
Margin and Trading Arrangements • Maintenance or variance margin - an established value below which a trader’s margin may not fall. • Margin call - when the maintenance margin is reached, broker will ask for additional margin funds • Futures follow this pay-as-you-go procedure, while forwards are simply held until maturity (no funds transferred until then)
At Delivery Date • Convergence of Price - as maturity approaches the spot and futures price converge • Delivery - Actual commodity of a certain grade with a delivery location or for some contracts cash settlement • E.g. S&P500 futures
Regulations • Futures market regulated by the Commodity Futures Trading Commission (CFTC) • May set limits on how much futures price may change from day to day • Limit violent price fluctuations • Does not always reach this goal
Trading Strategies • Speculation • short - believe price will fall • long - believe price will rise
Speculation Example • You believe that crude oil prices are going to increase • Current futures price is $52.67 per barrel • Each contract calls for the delivery of 1,000 barrels • If crude oil is selling at $54.67 at contract maturity, the speculator that entered the long side will profit $2,000 per contract!
Speculator: why futures? • Why is the speculator interested in futures rather than in the underlying asset directly? • Smaller Transaction costs • Must post margin that is considerably less than value of underlying asset (i.e. greater leverage)
Trading Strategies (cont’d) • Hedging – insulate against price movements • long hedge - protecting against a rise in price • short hedge - protecting against a fall in price
Hedger Examples • Oil distributors wants to sell 100,000 barrels of Oil in November and wishes to hedge against possible decline in price • Take a short position on the same underlying • At Delivery he gets PT from oil sale and F0-PT from futures • In other words she always makes F0
Hedger Examples (cont’d) • A power supplier planning to purchase oil is afraid that prices might rise by the time of the purchase • Take a long position on oil futures • At maturity she always makes F0
Cross hedging • Exact future hedging may be impossible • Necessary futures contract may not be traded • Example: • manager of a diversified portfolio would like futures on every single asset that is part of the portfolio, but they do not exists • Solution hedge with index futures: highly correlated with well diversified portfolio • Cross hedging: hedging a position using futures on another asset
Basis and Basis Risk • Basis - the difference between the futures price and the spot price • over time the basis will likely change and will eventually converge • Basis Risk - the variability in the basis that will affect profits and/or hedging performance
Speculating on the basis • Hold 100 ounces of gold • Short one gold futures contract (based on 100 ounces) • Today prices: $391 (gold) and $396 (futures) • Tomorrow’s prices $394 (gold) and $398.50 (futures) • The basis shrinks by $0.50 an ounce: net gain!
Spread (Futures) • Taking a long position in a futures contract of one maturity and a short position in a contract at a different maturity both on the same commodity
Speculating on the spread • Hold a September maturity contract long • Hold a June contract short • Sep futures increases by 5 cents • June futures increases by 4 cents • The net gain is 1 cent!
Futures Pricing • Spot-futures parity theorem - two ways to acquire an asset for some date in the future • Purchase it now and store it • Take a long position in futures • These two strategies must have the same market determined costs
Parity Example Using Gold Strategy 1: Buy gold now at the spot price (S0) and hold it until time T when it will be worth ST Strategy 2: Enter a long position in gold futures today and invest enough funds in T-bills (F0) so that it will cover the futures price of ST
Strategy A: Action Initial flows Flows at T Buy gold -So ST Strategy B: Action Initial flows Flows at T Long futures 0 ST - FO Invest in Bill FO/(1+rf)T - FO /(1+rf)T FO Total for B - FO /(1+rf)T ST Parity Example Outcomes
Price of Futures with Parity Since the strategies have the same flows at time T FO / (1 + rf)T = SO FO = SO (1 + rf)T The futures price has to equal the carrying cost of the gold
Example-Futures Pricing • Gold currently sells for $400 an ounce • Risk free rate is 0.5% per month • What is the price of a six month futures contract on an ounce of gold?
The futures price of gold! • The futures price of gold is
An Arbitrage Opportunity? • Suppose that the price of gold futures is $413 (rather than $412.15, as just computed) • Can you construct an arbitrage?
Step 1 • Construct a zero cost position at time 0 • Buy gold for $400 • Borrow at the risk-free rate $400 • Enter short futures position (Fo=$413): this does not cost a dime today!
Step 2 • Verify that the cash flow at maturity is different from zero • Repay debt: -$400x(1.005)6=-$412.15 • Got gold: ST • Close out short futures position: $413-ST • The net profit is $0.85
Extensions of spot-futures parity • If an asset has a dividend yield of d, the futures price is • In the homework you will be asked to derive this!
Stock Index Contracts • Available on both domestic and international stocks • Use a multiplier (see next slide) • Advantages over direct stock purchase • lower transaction costs • better for timing or allocation strategies • takes less time to acquire the portfolio
Index Arbitrage Exploiting mispricing between underlying stocks and the futures index contract Futures Price too high - short the future and buy the underlying stocks Futures price too low - long the future and short sell the underlying stocks Difficult to do in practice Transactions costs are often too large Trades cannot be done simultaneously
Additional Financial Futures Contracts • Foreign Currency • Forwards versus futures • Interest Rate Futures • Short position gains when interest rate rise and bond price falls
Swaps • Large component of derivatives market • Over $100 trillion outstanding • Interest Rate Swaps • Currency Swaps • Example: Interest rate swaps based on LIBOR
