1616C h a p t e r

Futures ContractsFutures Contracts

second edition

Fundamentals

of InvestmentsValuation & Management

Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Contracts

Our goal in this chapter is to discuss the basics of futures contracts and how their prices are quoted in the financial press. We will also look at how futures contracts are used and the relationship between current cash prices and futures prices.

Goal

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Contracts Basics

Forward contractAgreement between a buyer and a seller, who both commit to a transaction at a future date at a price set by negotiation today.

Futures contractContract between a seller and a buyer specifying a commodity or financial instrument to be delivered and paid for at contract maturity. The specified price is called the futures price.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Contracts Basics

While a forward contract can be struck between any two parties, futures contracts are managed through an organized futures exchange.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Contracts Basics

Established in 1848, the Chicago Board of Trade (CBOT) is the oldest organized futures exchange in the United States.

It grew with the westward expansion of American ranching and agriculture, and is today, the largest, most active futures exchange in the world.

In the 1970s, financial futures were introduced. They are so successful that they now constitute the bulk of all futures trading.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Contracts Basics

In general, futures contracts must stipulate at least the following five terms:

The identity of the underlying commodity or financial instrument.

The futures contract size. The futures maturity date, also called the expiration

date. The delivery or settlement procedure. The futures price.

Futures Contracts Basics16 - 7

Futures Contracts Basics

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2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Work the Web

Visit the websites of these futures exchanges:http://www.cbot.comhttp://www.nymex.comhttp://www.cme.comhttp://www.kcbt.comhttp://www.nybot.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Work the Web

For futures prices and price charts, visit:http://www.futuresworld.comhttp://futures.pcquote.comhttp://www.thefinancials.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Why Futures?

A futures contract represents a zero-sum game between a buyer and a seller. Any gain realized by the buyer is exactly equal to

the loss realized by the seller, and vice versa.

Futures contracts can be used for speculation or for hedging. Hedgers transfer price risk to speculators, while speculators absorb price risk. Hedging and speculating are complementary

activities.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Speculating with Futures

Buying futures is often referred to as “going long,” or establishing a long position. A long position profits from a futures price increase.

Selling futures is often called “going short,” or establishing a short position. A short position profits from a futures price decrease.

A speculator accepts price risk by going long or short to bet on the future direction of prices.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Hedging with Futures

A hedger is a trader who seeks to transfer price risk by taking a futures position opposite to an existing position in the underlying commodity or financial instrument.

Suppose a large operating inventory is needed. The sale of futures to offset potential losses from falling prices is called a short hedge.

When some commodity is needed in the future, the purchase of futures to offset potential losses from rising prices is called a long hedge.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Work the Web

To learn more about futures, visit:http://www.futurewisetrading.comhttp://www.usafutures.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Trading Accounts

A futures exchange, like a stock exchange, allows only exchange members to trade on the exchange.

Exchange members may be firms or individuals trading for their own accounts, or they may be brokerage firms handling trades for customers.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Trading Accounts

There are several essential things to know about futures trading accounts.

Margin is required - initial margin as well as maintenance margin.

The contract values are marked to market on a daily basis, and a margin call will be issued if necessary.

A futures position can be closed out at any time. This is done by entering a reverse trade.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Work the Web

For a list of online futures brokers, visit the Commodities & Futures section of Investor Links at:http://www.investorlinks.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Cash Prices

Cash price (or spot price)The price of a commodity or financial instrument for current delivery.

Cash market (or spot market)The market in which commodities or financial instruments are traded for essentially immediate delivery.

Cash Prices

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Cash Prices

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2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Cash-Futures Arbitrage

Earning risk-free profits from an unusual difference between cash and futures prices is called cash-futures arbitrage. In a competitive market, cash-futures arbitrage has

very slim profit margins.

Cash prices and futures prices are seldom equal. The difference between the cash price and the futures price for a commodity is known as basis.

basis = cash price – futures price

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Cash-Futures Arbitrage

For commodities with storage costs, the cash price is usually less than the futures price, i.e. basis < 0. This is referred to as a carrying-charge market.

Sometimes, the cash price is greater than the futures price, i.e. basis > 0. This is referred to as an inverted market.

Basis is kept at an economically appropriate level by arbitrage.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Spot-Futures Parity

The relationship between spot prices and futures prices that holds in the absence of arbitrage opportunities is known as the spot-futures parity condition.

Let F be the futures price, and S be the spot price. If r is the risk-free rate per period, and the futures contract matures in T periods, then the spot-futures parity condition is:

TT rSF 1

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More on Spot-Futures Parity

Let D be the dividend (or coupon payment) paid in one period, at or near the end of the futures contract’s life. Then, the spot-futures parity condition becomes F = S (1 + r) – D.

Alternatively, we can write the dividend-adjusted parity result as F = S (1 + r – d ), where dividend yield d = D/S. Then

TT drSF 1

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Stock Index Futures

There are a number of futures contracts on stock market indexes. The S&P 500 contract is one of the most important ones.

Because of the difficulty of actual delivery, stock index futures are usually settled in cash.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Index Arbitrage

Index arbitrage refers to the strategy of monitoring the futures price on a stock index and the level of the underlying index to exploit deviations from parity.

Index arbitrage is often implemented as a program trading strategy. Program trading accounts for about 15% of total trading volume on the NYSE, and about 20% of all program trading involves stock-index arbitrage.

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Index Arbitrage

Another phenomenon often associated with index arbitrage (and more generally, futures and options trading) is the triple witching hour effect.

S&P 500 futures contracts and options, and various stock options, all expire on the third Friday of four particular months per year. The closing out of all the positions held sometimes lead to unusual price behavior.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Work the Web

For more information on stock index futures, visit the CBOT website at:http://www.cbot.com

For information on program trading, visit:http://www.programtrading.com

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Hedging Stock Market Risk with Futures

Cross-hedging refers to hedging a particular spot position with futures contracts on a related, but not identical, commodity or financial instrument.

For example, you may decide to protect your stock portfolio from a fall in value (caused by a falling stock market) by establishing a short hedge using stock index futures.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Hedging Stock Market Risk with Futures

The number of stock index futures contracts needed to hedge a stock portfolio effectively can be determined as follows:

F

PP

V

V

β contracts ofNumber

where P = beta of the stock portfolioVP = value of the stock portfolioVF = value of a single futures contract

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Hedging Interest Rate Risk with Futures

The protect a bond portfolio against changing interest rates, we may cross-hedge using futures contracts on U.S. Treasury notes.

A short hedge will protect your bond portfolio against the risk of a general rise in interest rates during the life of the futures contracts.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Hedging Interest Rate Risk with Futures

To hedge a bond portfolio effectively,

FF

PP

VD

VD

needed contracts ofNumber

where DP = duration of the bond portfolioVP = value of the bond portfolioDF = duration of the futures contractVF = value of a single futures contract

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Hedging Interest Rate Risk with Futures

As a useful rule of thumb, the duration of an interest rate futures contract is equal to the duration of the underlying instrument plus the time remaining until contract maturity.

FUF MDD

where DF = duration of the futures contractDU = duration of the underlying instrumentMF = time remaining until contract maturity

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Futures Contract Delivery Options

The cheapest-to-deliver option refers to the seller’s option to deliver the cheapest instrument when a futures contract allows several instruments for delivery.

For example, U.S. Treasury note futures allow delivery of any Treasury note with a maturity between 6 1/2 and 10 years. Note that the cheapest-to-deliver note may vary over time.

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Futures Contracts Basics Modern History of Futures Trading Futures Contract Features Futures Prices

Why Futures? Speculating with Futures Hedging with Futures

Futures Trading Accounts

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Cash Prices versus Futures Prices Cash Prices Cash-Futures Arbitrage Spot-Futures Parity More on Spot-Futures Parity

2002 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Chapter Review

Stock Index Futures Basics of Stock Index Futures Index Arbitrage Hedging Stock Market Risk with Futures Hedging Interest Rate Risk with Futures Futures Contract Delivery Options