Chapter 19

Chapter 19 Futures contracts and forward rate agreements Websites: www.asx.com.au www.cme.com www.cbot.com www.liffe.com www.hkex.com.hk www.sgx.com

Learning objectives • Consider the nature and purpose of derivative products • Outline features of a futures transaction • Review the types of futures contracts available through a futures exchange • Identify why participants use derivative markets and how futures are used to hedge price risk • Identify risks associated with using a futures contract hedging strategy • Explain and illustrate the use of an FRA for hedging interest rate risk • Describe the use of a forward rate agreement for hedging interest rate risk

Chapter organisation 19.1 Hedging using futures contracts 19.2 Main features of a futures transaction 19.3 Futures market instruments 19.4 Futures market participants 19.5 Hedging: risk management using futures 19.6 Risks in using futures markets for hedging 19.7 Forward rate agreements (FRAs) 19.8 Summary

19.1 Hedging using futures contracts • Futures contracts and FRAs are called derivatives because they derive their price from an underlying physical market product • Two main types of derivative contracts 1. Commodity (e.g. gold, wheat and cattle) 2. Financial (e.g. shares, government securities and money market instruments) • Derivative contracts enable investors and borrowers to protect assets and liabilities against the risk of changes in interest rates, exchange rates and share prices (cont.)

19.1 Hedging using futures contracts (cont.) • Hedging involves transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party • A futures contract is the right to buy or sell a specific item at a specified future date at a price determined today • The change in the market price of a commodity or security is offset by a profit or loss on the futures contract (cont.)

19.1 Hedging using futures contracts (cont.) • Example: A farmer wants to sell wheat in a couple of months, but is concerned that the price is going to fall in the mean time. How can the farmer hedge this price risk? • Solution • Enter into a wheat futures contract to sell • If wheat prices fall, the futures contract will rise in value, offsetting the loss in the physical market from the fall in the wheat price • If wheat prices rise, the futures contract will fall in value, offsetting the gain in the physical market from a rise in the wheat price

19.2 Main features of futures transactions • Although futures contracts are highly standardised, variations exist between countries owing to: • The types of contract being based on the underlying security traded in that country • ASX Trade24 (formerly Sydney Futures Exchange) Commonwealth Treasury bonds; CBOT (Chicago Board of Trade) US Treasury bonds • Differences in the quotation convention • Clean price bond quotation in US and European markets— present value of a bond less accrued interest • Yield to maturity bond quotation in Australian markets (cont.)

19.2 Main features of futures transactions (cont.) • Orders and agreement to trade • Futures contracts are highly standardised and an order normally specifies: • whether it is a buy or sell order • the type of contract (varies between exchanges) • delivery month (expiration) • price restrictions (if any) (e.g. limit order) • time limits on the order (if any) (cont.)

19.2 Main features of futures transactions (cont.) • Margin requirements • Both the buyer (long position) and the seller (short position) pay an initial margin, held by the clearing house, rather than the full price of the contract • Margins are imposed to ensure traders are able to pay for any losses they incur owing to unfavourable price movements in the contract (cont.)

19.2 Main features of futures transactions (cont.) • Margin requirements (cont.) • A contract is marked-to-market on a daily basis by the clearing house • i.e. repricing of the contract daily to reflect current market valuations • Subsequent margin calls may be made, requiring a contract holder to pay a maintenance margin to top up the initial margin to cover adverse price movements (cont.)

19.2 Main features of futures transactions (cont.) • Closing out of a contract • Involves entering into an opposite position • Example: • Company S initially entered into a ‘sell one 10-year Treasury bond contract’ with company B • Company S would close out the position by entering into a ‘buy one 10-year Treasury bond contract’ for delivery on the same date, with a third party, say company R • The second contract reverses or closes out the first contract and company S would no longer have an open position in the futures market (cont.)

19.2 Main features of futures transactions (cont.) • Contract delivery • Most parties to a futures contract: • manage a risk exposure or speculate • do not wish to actually deliver or receive the underlying commodity/instrument and close out of the contract prior to delivery date • ASX Trade24 requires financial futures in existence at the close of trading in the contract month to be settled with the clearing house in one of two ways • Standard delivery—delivery of the actual underlying financial security • Cash settlement (cont.)

19.2 Main features of futures transactions (cont.) • Contract delivery (cont.) • Settlement details, including the calculations of cash settlement amounts, for each contract traded on the ASX Trade24 are available on the exchange’s website at www.asx.com.au

19.3 Futures market instruments • Futures markets can be established for any commodity or instrument that: • is freely traded • experiences large price fluctuations at times • can be graded on a universally accepted scale in terms of its quality • is in plentiful supply, or cash settlement is possible (cont.)

19.3 Futures market instruments (cont.) • Examples: • Commodities • Mineral—silver, gold, copper, petroleum, zinc • Agricultural—wool, coffee, butter, wheat and cattle • Financial • Currencies—pound sterling, euro, Swiss franc • Interest rates • Short-term instruments—US 90-day treasury bills, three-month eurodollar deposits, Australian 90-day bank-accepted bills • Longer-term—US 10-year T-notes, Australian three-year and 10-year Commonwealth Treasury bonds • Share price indices—S&P/ASX 200 Index (cont.)

19.3 Futures market instruments (cont.)

19.4 Futures market participants • Four main categories of participants • 1. Hedgers • 2. Speculators • 3. Traders • 4. Arbitragers • These participants provide depth and liquidity to the futures market, improving its efficiency (cont.)

19.4 Futures market participants (cont.) 1. Hedgers • Attempt to reduce the price risk from exposure to changes in interest rates, exchange rates and share prices • Take the opposite position to the underlying, exposed transaction • Example: • An exporter has USD receivable in 90 days. To protect against falls in USD over the next three months, the exporter enters into a futures contract to sell USD (cont.)

19.4 Futures market participants (cont.) 2. Speculators • Expose themselves to risk in an attempt to make profit • Enter the market with the expectation that the market price will move in a direction favourable for them • Example: • Speculators who expect the price of the underlying asset to rise will go long and those who expect the price to fall will go short (cont.)

19.4 Futures market participants (cont.) 3. Traders • Special class of speculator • Trade on very short-term changes in the price of futures contracts (i.e. intra-day changes) • Provide liquidity to the market (cont.)

19.4 Futures market participants (cont.) 4. Arbitragers • Simultaneously buy and sell to take advantage of price differentials between markets • Attempt to make profit without taking any risk • Example: • Differentials between the futures contract price and the physical spot price of the underlying commodity

19.5 Hedging: risk management using futures • Futures contracts may be used to manage identified financial risk exposures such as: • Hedging the cost of funds (borrowing hedge) • Hedging the yield on funds (investment hedge) • Hedging a foreign currency transaction • Hedging the value of a share portfolio

Hedging the cost of funds (borrowing hedge)

Hedging the yield on funds (investment hedge)

Hedging a foreign currency transaction

Hedging the value of a share portfolio

19.6 Risks in using futures markets for hedging • The risks of using the futures markets for hedging include the problems of: • standard contract size • margin risk • basis risk • cross-commodity hedging (cont.)

19.6 Risks in using futures markets for hedging (cont.) • Standard contract size • Owing to contract size the physical market exposure may not exactly match the futures market exposure, making a perfect hedge impossible • Table 19.6 (cont.)

19.6 Risks in using futures markets for hedging (cont.) (cont.)

19.6 Risks in using futures markets for hedging (cont.) • Margin payments • Initial margin required when entering into a futures contract • Further cash required if prices move adversely (i.e. margin calls) • Opportunity costs associated with margin requirements (cont.)

19.6 Risks in using futures markets for hedging (cont.) • Basis risk • Two types of basis risk • Initial basis • The difference between the price in the physical market and the futures market at commencement of a hedging strategy • Final basis • The difference between the price in the physical market and the futures market at completion of a hedging strategy • A perfect hedge requires zero initial and final basis risk (cont.)

19.6 Risks in using futures markets for hedging (cont.) • Cross-commodity hedging • Use of a commodity or financial instrument to hedge a risk associated with another commodity or financial instrument • Often necessary as futures contracts are available for few commodities or instruments • Selection of a futures contract that has price movements that are highly correlated with the price of the commodity or instrument to be hedged

19.7 Forward rate agreements (FRAs) • The nature of the FRA • An FRA is an over-the-counter product enabling the management of an interest rate risk exposure • It is an agreement between two parties on an interest rate level that will apply at a specified future date • Allows the lender and borrower to lock in interest rates • Unlike a loan, no exchange of principal occurs • Payment between the parties involves the difference between the agreed interest rate and the actual interest rate at settlement (cont.)

19.7 Forward rate agreements (FRAs) (cont.) • The nature of the FRA (cont.) • Disadvantages of FRAs include: • risk of non-settlement, i.e. credit risk • no formal market exists • The FRA specifies: • FRA agreed date, fixed at start of FRA • notional principal amount of the interest cover • FRA settlement date when compensation is paid • contract period on which the FRA interest rate cover is based (end date) • reference rate to be applied at settlement date (cont.)

19.7 Forward rate agreements (FRAs) (cont.) (cont.)

19.7 Forward rate agreements (FRAs) (cont.) • Settlement amount = FRA settlement rate - FRA agreed rate • where • is = reference rate at the FRA settlement rate, expressed as a decimal • ic = the fixed FRA agreed rate, expressed as a decimal • D = the number of days in the contract period • P = the FRA notional principal amount (cont.)

19.7 Forward rate agreements (FRAs) (cont.) • Using an FRA for a borrowing hedge • Example: On 19 September this year a company wishes to lock in the interest rate on a prospective borrowing of $5 000 000 for a six-month period from 19 April next year to 19 October of the same year. An FRA dealer quotes ‘7Mv13M (19) 13.25 to 20’. On 19 April the BBSW on 190-day money is 13.95% per annum. • where • is = 0.1395 (on 19 April) • ic = 0.1395 (on 19 September) • D = 183 days (from 19 April to 19 October) • P = $5 000 000 (cont.)

19.7 Forward rate agreements (FRAs) (cont.) • Using an FRA for a borrowing hedge (cont.) As interest rates have risen over the period, the settlement of $15 379.19 is paid by the FRA dealer to the company (cont.)

19.7 Forward rate agreements (FRAs) (cont.) (cont.)

19.7 Forward rate agreements (FRAs) (cont.) • Main advantages of FRAs • Tailor-made, over-the-counter contract, providing great flexibility with respect to contract period and the amount of each contract • Unlike a futures contract, an FRA does not have margin payments • Main disadvantages of FRAs • Risk of non-settlement (credit risk) • No formal market exists and concern about difficulty closing out FRA position is overcome by entering into another FRA opposite to the original agreement

19.8 Summary • A futures contract • An agreement between two parties to buy or sell a specified commodity or instrument at a specified date in the future, at a price specified today • May be used as a hedging strategy by opening a position today that requires a closing transaction that is the reverse of the exposed transaction in the physical market • Limitations include margin calls, imperfect hedging owing to basis risk, and availability (cont.)

19.8 Summary (cont.) • FRAs • Over-the-counter contracts specifying an agreed interest rate to apply at a future date • Advantages include: • flexibility—they are tailor-made • no margin calls • Disadvantages include: • non-settlement or credit risk • lack of formal market

Chapter 19

Chapter 19

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Chapter 19

Chapter 19

Chapter 19

19 Chapter 19

Chapter 19

Chapter 19

Chapter 19

CHAPTER 19

Chapter 19

Chapter 19

Chapter 19

Chapter 19

Chapter 19

Chapter 19

Chapter 19

Chapter 19

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CHAPTER 19