Chapter 26

FINANCIAL FUTURES MARKETS

Futures Contracts

Exchange traded productsRegulated by the CFTCTypes of Futures

Commodity Futures Financial Futures

stock index futuresinterest rate futurescurrency futures

The value of a futures contract is derived from the value of the underlying instrument

Futures Contracts

A firm legal agreement between a buyer and a seller. the buyer agrees to take delivery of an

asset at a specified price at the end of a designated period of time.

the seller agrees to make delivery of an asset at a specified price at the end of a designated period of time.

Futures Contracts

Key Elements Futures Price Settlement Date or Delivery Date Underlying Asset

Futures Positions Long futures Short futures

Liquidating a Futures Position

Settlement Dates March, June, September, December Nearby futures contracts Most distant futures contracts

Liquidating a Futures Position Take an offsetting position in the same contract

prior to the settlement date Take delivery of the underlying asset on the date

of settlement

Open Interest

Role of Clearinghouse

Functions of Clearinghouse guarantees that both parties to futures

contracts satisfy their obligations simplifies the unwinding of futures

positions prior to the settlement date

Margin Requirements

Initial Margin minimum dollar amount per futures

contract provides investor with substantial leverage

Maintenance Margin minimum level to which an equity position

may fall due to adverse price movementsVariation Margin

amount necessary to bring equity account back to initial margin level

Daily Settlement

Futures contracts are marked-to-market on a daily basis a buyer (seller) realizes a profit if the

futures price increases (decreases) a buyer (seller) realizes a loss if the

futures price decreases (increases)Daily price limits restrict the

maximum daily price moves

Market Structure

Exchange Trading Pit Seat on the exchange

Floor Traders Locals Floor or pit brokers Futures commissions merchant

Electronic Trading Systems

Futures Versus Forward Contracts

Type of Contract

Trading Location

Clearinghouse

Settlement

Delivery

Collateral

Credit Risk

The Role of Futures in Financial Markets

Altering Risk Exposure of an AssetPrice DiscoveryArbitrage ProcessIncreased Price Volatility of

Underlying Asset

U.S. Financial Futures Markets

Stock Index Futures MarketInterest Rate Futures Market

Treasury Bill Futures Eurodollar CD Futures Treasury Bond Futures Treasury Note Futures Agency Futures

The GAO Study on Financial Derivatives

Principal Conclusions A legal framework is needed which will

set basic standards to effectively manage derivative risk.

Financial reporting requirements are inadequate for derivative instruments.

Coordination with foreign regulators is needed.

Policymakers and regulators should not stifle the use of derivatives.

Forward Rate Agreements

Over-the-counter equivalent of the exchange-traded futures contracts on short-term rates.

Elements of an FRA: Contract rate Reference rate Notional amount Settlement rate Settlement date

Forward Rate Agreements

FRA buyer benefits if settlement rate > contract rate

FRA seller benefits if settlement rate < contract rate

Neither party benefits if settlement rate = contract rate