Futures Markets

• I. The Development of Futures Markets– 1. Chicago Board of Trade (1848) – grain

– 2. Chicago Mercantile Exchange (1898) – merge of Chicago Produce Exchange & Chicago Butter & Egg Board

– 3. Financial Futures

• A. Foreign Currency Futures (1972)

• B. GNMA Futures (1975)

• C. T-Bill Futures (1976)

• D. T-Bond Futures (1977)

• E. Eurodollar Futures (1981)

• S&P500 Index Futures (1982)

• Dow-Jones Index Futures (1997)

• II. Futures Contracts– 1. Forward Contract vs. Futures Contract– 2. Basics of Futures Contract

• Types of Futures– Grains & Oilseeds– Livestock & Meat– Food and Fiber– Metals & Energy– Financials & others

• Quotations • (Bonds) • (Contract Specifications)

• III. Mechanics of Trading– 1. Trading Pits vs. GLOBEX– 2. The Clearing House

– 3. Marking to Market• Initial Margin & Maintenance Margin (Performance

Bond)• Daily Settlement

– Example

• Cash Deliver vs. Actual Delivery– Actual delivery: less than 1%– Cash delivery: stock index futures

• Regulations– CFTC: Commodity Futures Trading Commissions– Price Limit (e.g., silver @ $1/per day)

• IV. Futures Market Strategies– 1. Hedging

• Short Hedge– Long cash, short futures

• Long Hedge-short cash, long futures

-Examples

- If you own an asset - If you plan to sell an asset - If you are short an asset - If you are committed to buying an asset in the future - If you have issued a floating rate liability - If you plan to issue a liability

• Bond Portfolio _____ Hedge• A long-term bond portfolio manager forecasts that interest rate will increase over

the next few months. The manager holds a portfolio of $1 million face value, 11-7/8s, 2023 corporate bond.

Date Spot Markets Futures Markets

3/25 Market yield= 11.74%

Market value = $1,010,000

Futures price = 70-16/32

Yield = 14.92%

3/25 No action Short 15 contracts

1,010,000/70500= 14.32

4/28 Yield increases to 12.44% Price of T-bond futures decreases to 66-23/32

Market value of cash bond = 95-22/32

Long 15 June T-bond futures

4/28 Loss = 1,010,000 – 956,875

= 53,125

Gain = (70,500-66,718) (15)

= 56,730

• Stock Portfolio Short Hedge – On 3/1, a portfolio manager was concerned about the market over the next six months.

Stock Price (3/1) Shares MV (3/1) Price (9/2) MV (9/2)

GLW 14.68 15,000 220,200 19.50 292,500

WFMI 126.35 1,000 126,350 128.25 128,250

XMSR 31.75 4,000 127,000 34.50 138,000

INTC 22.48 5,000 112,400 25.60 128,000

DELL 36.25 5,000 181,250 34.50 172,500

WMT 47.75 5,000 238,750 44.55 222,750

AMT 18.65 15,000 279,750 23.65 354,750

1,285,700 1,436,750

• On 3/1, the SP500 index futures was @1,190, the manager shorted 5 contracts {[1,285,700/ (1,190 x 250)]=4.3}

• On 9/2, SP500 index futures is @ 1,218, the manager longs 5 contracts .

• Loss in the futures: (1,218-1,190) x250 x 5 = 35,000

• 2. Hedge Ratio– Naïve hedge ratio

– Minimum variance hedge ratio• Run a linear regression line S = + F, where is the

minimum variance hedge ratio

• # of futures contract: N = (S/F)

• 3. Which futures commodity?– Cross Hedge – choose the one that has high correlation

between futures price and underlying asset price

• 4. Which Expiration?– Choose a future with expiration month close to but after

the hedge terminates

– Deferred contract may have liquidity problem

• V. Futures Pricing– Spot-Futures Parity (Cost of Carry Model)

– 1. F0 = S0 (1+r)T

• Example: F0 = 360(1.05)1 = 378

– 2. Arbitrage occurs when the equilibrium relation is violated (e.g., F0 = 380)

• Example

T0 T1 .

T0: borrow $360 $360

buy gold -$360

short futures@380 0

T1: deliver gold $380

repay loan (P&I) -$378

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Cash flows 0 +2

• V. Other Futures & Forwards– 1. Options on Futures

– 2. Hedging with Foreign Currency Forwards• Scenario: On June 1, a multinational firm with a British subsidiary decides

it will need to transfer ￡ 10 million from an account in London to an account with a NY bank. Transfer will be made on September 6. The firm is concerned that pound will weaken.

Date Spot Market Forward Markets

6/1 The spot exchange rate is $1.362 per pound; forward rate is $1.357

Forward value of fund=10,000,000($1.357)=$13,570,000

Short pounds forward for delivery on 9/6 @ $1.357

9/6 The spot rate is $1.2375 Deliver pounds and receive 10,000,000($1.357)=$13,570,000

•Analysis: The ￡ end up worth $13,570,000 – 12,375,000 = $1,195,000 less but are delivered on the forward contract for $13,570,000, thus eliminating the risk.