What is it?

1. What is it? • Financial futures are standardized contracts calling for future delivery of a specified number or notional value of a specified financial instrument • For a specified price • At a designated future date • The price at which delivery will be made is determined at the present time, but delivery is scheduled for some future date. • Example: An investor may trade through the Chicago Board of Trade (CBOT) on June 15 to purchase a futures contract in GNMA certificates for actual delivery on November 26. The price and the number of contracts to be traded are set at the time of purchase or sale (June 15), and not at the time of delivery (November 26).

2. What is it? • The financial futures market includes: • Currency Futures: Contracts on foreign currencies • Interest-Rate Futures: Contracts on U.S. Treasury bonds, notes, bills, GNMA bonds, foreign government bonds, and other interest-related notional instruments, or benchmarks based upon such things as the Federal Funds Rate or the LIBOR (London Inter-Bank Offered Rate) • Index Futures: Contracts on broad-based domestic or foreign stock indexes, or contracts on indexes of interest-related instruments • Narrow-Based Index (NBI) Futures: Contracts based on a small basket of stocks from a narrow sector of the market • Single Stock Futures: Contracts on individual stocks

3. What is it? • Two distinct trading arenas comprise the financial futures market. • Exchange-traded futures are contracts listed on organized exchanges, such as the Chicago Mercantile Exchange. • These contracts have standardized features with respect to the amount of the product involved in each contract, the margin requirement, the settlement dates, etc. • They are subject to the “mark-to-market” rule that essentially settles differences in the long and short positions daily.

4. What is it? • Over-the-counter futures are contracts within a negotiated private placement market. • This market involves contracts on millions of dollars of financial instruments. • These contracts are much less standardized. • The principal participants are large financial institutions and international corporations, professional traders and arbitrageurs, and governments.

5. What is it? • The real purpose of financial futures is to transfer the risk (and potential reward) of price fluctuations from the hedger to the speculator, not to take actual possession of assets. • Most investors “close out” their sale or purchase positions by entering into an “offsetting transaction” instead of taking or making delivery. • This is accomplished by simply reversing their original position. • The futures market is a “zero-sum” market. • For each investor who gains one dollar, another investor must lose one dollar. • For each long position in the futures market, there is an equal, but opposite, short position. • The “average” investor earns zero.

6. When is the use of this tool indicated? • Investors have one of three objectives when investing in financial futures: • Speculating • Hedging • Arbitrage • Speculating on anticipated increases or decreases in the price of the underlying financial instrument, or to speculate on a particular stock, bond, currency, or other financial instrument’s performance relative to another’s performance. • Individuals can take large risks by purchasing financial futures contracts at a fraction of the price of actually owning the underlying securities or currencies.

7. When is the use of this tool indicated? • Hedge current holdings of a particular position in a financial instrument against the risk of an adverse price change. • Establish in advance a definite purchase or selling price for a financial instrument that actually will not be bought or sold until some time in the future. • Temporarily alter a stock portfolio’s composition without having to acquire or liquidate shares of stock; this strategy may be employed for speculative and hedging purposes. • Create investment portfolios with specific risk and reward characteristics by combining stock futures with exchange-traded equity options; used for speculative, hedging or arbitraging purposes.

8. Advantages • The terms of futures contracts are standardized by the various exchanges where they are traded. • The coupon rate, maturity, issuer, and other terms are the same for each contract of a particular type. • Financial futures offer investors a high degree of “leverage” on their investments because of the low margin requirements involved. • The financial futures market is highly liquid. • All futures contracts are “guaranteed” by the clearinghouse that processes the transactions. • In actuality, the clearinghouse becomes the other side of every trade: the buyer from every seller and the seller to every buyer. • This improves market performance by eliminating concerns over the creditworthiness of the opposing parties, assuring delivery of the underlying securities, and adding to flexibility in closing out positions.

9. Disadvantages • Financial futures are an extremely volatile investment area where substantial price changes can take place in a very short period of time. • Investors must have both the financial and emotional capacity to operate in this area where gains and losses are settled on a daily basis. • Investors are subject to frequent margin calls. • They must be prepared to invest additional funds or risk having their futures positions closed out by the brokerage firm. • Trading strategies in financial futures tend to be complex arrangements compared to many other kinds of investments. • A futures transaction generally accompanies some other investment rather than being carried out in isolation.

10. Tax Implications • Gains and losses on regulated futures contracts are capital gains and losses, regardless of the nature of the underlying property. • Any gain or loss required to be reported by an investor on a futures contract is treated as if 40% of the gain or loss is short-term and 60% is long-term gain or loss. • Net capital gains are generally taxable at a maximum rate of 15%. • Under the “mark-to-market” tax rules, gains and losses on futures contracts owned by an investor must be reported annually, even if the investor has not realized such gains or losses. • Ownership may be at the end of the tax year or at any time during the year.

11. Alternatives • Investors can use put and call stock options to accomplish some of the same purposes as financial futures. • Investors with large portfolios of common stock can use options to hedge their stock positions while increasing the income from those portfolios. • Speculators can purchase calls (puts) in anticipation of an increase (decrease) in stock prices, and invest a relatively small sum compared with the cost of actually buying (or selling) the underlying stock. • Stock purchase warrants also offer some of the same advantages in terms of leverage and relatively low investment. • They are particularly attractive to speculators who hope to profit from a much larger percentage increase in the value of a warrant if the underlying stock increases in value.

12. Alternatives • Investors can participate in futures through a managed financial futures account. • Similar in concept to a common stock mutual fund • Investors do not have their own individual trading accounts. • The investor’s money is combined with that of other pool participants and traded as a single account. • Gains or losses are shared in proportion to each participant’s investment in the pool. • The advantages of this arrangement are that it offers potentially greater diversification of risks, participants’ losses are generally limited to their investment in the pool, and the individual participants are not generally subject to margin calls. • The disadvantages include the risk of bad management and management fees and organizational or administrative expenses.

13. Where and How do I get it? • Financial futures are traded on several organized exchanges. • Most are located in either Chicago or New York • Chicago Board of Trade (CBOT) • New York Futures Exchange (NYFE) • Buying or selling financial futures is quite similar in many ways to buying or selling stocks or bonds. • Transactions must be carried out through a “margin account” with a brokerage firm that sends orders to the trading floors of exchanges. • The position of the buyer or seller remains “open” until either • The buyer accepts delivery of the underlying instruments on the settlement date, or • The buyer’s or seller’s position is “closed out” by the execution of another trade that is opposite of the first transaction.

14. What fees or other costs are involved? • Commissions on the purchase or sale of financial futures are similar to those paid on other security transactions. • Brokerage firms typically charge a percentage of the value of the transaction with minimum commission of $25 or $30. • Brokerage charges are relatively high on single unit trades. • Most active investors trade in multiples of five or ten contracts at a time.

15. How do I select the best of its type? • An accurate forecast of interest rates is an essential part of an effective financial futures strategy. • Estimating the direction of interest rate changes and the amount of change is critical to establishing profitable contract positions. • If interest rates fall, buyers of financial futures contracts will generally benefit. • When interest rates fall, the value of securities such as T-bills and GNMA certificates will increase, and so will the value of contracts to take delivery on these issues in the future. • Sellers of futures contracts will tend to lose money in these circumstances. • If interest rates rise, buyers of futures contracts will see the value of their contracts decline. • Sellers will benefit from the fall in value of the underlying securities.

16. How do I select the best of its type? • Individuals and institutions seeking to hedge their portfolios should determine the appropriate maturity structure of those portfolios in selecting the best financial futures contract. • The portfolio hedged by the futures contract should be of approximately the same maturity as the securities underlying the futures contract. • The period of time until settlement of the futures contract should be considered before any purchase or sale is made. • The longer the term of the contract, the more risk is generally involved for sellers. • Buyers have a greater advantage here. • These conditions are reflected in the price of the contract along with the volatility of the underlying securities.

17. Where can I find out more about it? • Major brokerage firms can provide brochures and analysis • Exchange publications • Chicago Board of Trade (www.cbot.com) • CFE: CBOE Futures Exchange (cfe.cboe.com) • Chicago Mercantile Exchange (www.cme.com) • Kansas City Board of Trade (www.kcbt.com/vl_futures_options.html) • The New York Board of Trade (www.nybot.com) • Specialists at larger brokerage firms often publish reports and recommendations.