26 The Financial Futures Market

• futures and options are derivative securities, i.e. assets that derive their value from an underlying asset
• derivatives began in the 1970s, when rising interest rate and exchange rate volatility created a demand for tools to manage the risk
• two types of investors in the futures market
• hedgers
• face risk due to fluctuating asset prices (actually own asset or buy the asset), use futures contracts to lock in a price and offset the risk
• speculators
• do not own or buy the underlying asset, but use futures contracts to profit from belief about future price changes
• do not enter into futures contract to manage risk, but actually create risk

I.  Futures Contracts

• two counterparties
• contract for a trade to take place in the future, specifying the details today including
• the asset to be traded--the underlying
• when it will be traded--the settlement date
• how much it will cost--the futures price
• note: trades that take place immediately take place in the spot market or cash market
• buyer (long position) has the obligation to buy the underlying at the futures price on the settlement date
• seller (short position) has the obligation to sell the underlying at the futures price on the settlement date
• the value of each position depends on how prices change in the spot market
• example: futures contract for 1 cow, a futures price of $100
• case 1: mad cow disease leads to a shortage of cows and the price rises to $120
• buyer position gains because get to buy cow for only $100
• seller position loses because sell cow for below market price
• may not be an actual loss on paper, but it is in terms of opportunity cost
• rising prices for underlying is good for buyer, bad for the seller
• case 2: cow baby boom causes prices to fall to $80
• .buyer position loses because buy cow at above market value
• seller position gains because sell cow for a price better than cash market
• falling prices for underlying is bad for buyer, good for seller
• note that there is always a financial incentive to default on a futures contract by one counterparty no matter which way the prices move

II.  Futures Market

• the futures market originated in 1800s as a way for farmers to lock in prices for agricultural commodities, but financial futures started trading in 1970s
• interest rate futures (1975)
• currency futures(1972)
• stock index futures (1982)
• futures contracts are traded on exchanges
• Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBT) are largest
• regulated by Commodities and Futures Trading Commission (CFTC)
• exchange must demonstrate a unique economic purpose for a contract to CFTC to get permission to trade such a contract
• trading takes place in trading pits, with open outcry auctions
• exchanges perform two functions to make trading easier
• exchanges standardize contracts with respect to underlying, settlement date, and futures price
• traders choose from a set menu of contracts, they cannot customize their own contract
• standardization maximizes the number of buyers and sellers per contract, and helps buyers and sellers agree on terms, which promotes liquidity
• exchange acts as a clearinghouse, guaranteeing contracts against default for both buyers and sellers
• buyer and seller each have contract with exchange, not with each other
• this gives exchange a large exposure to default risk; the exchange controls this risk by
• requiring margin accounts for both buyer and seller
• deposit initial margin against future losses
• if losses become too large equity falls below maintenance margin
• much deposit additional cash (variation margin) to get back to initial margin or position is closed out by the exchange
• daily settlement on contracts
• daily price limits
• leverage:  upfront cost of futures contract, in terms of initial margin is a fraction of cost of actual asset
•    $5 initial margin, futures price of $100
• cost of 20 contracts is $100 BUT
• $20,000 worth of assets

III.  Types of Contracts (and uses, chapter 29 pp 564-7)

• Stock index futures
• S&P 500 index, 1982, CME
• cash settlement contracts, futures price is index level
• if index rises above futures price, then buyer gains and seller loses
• dollar value is determined by multiplying index level x $250 (the multiple)
• If S&P 500 rises from 1050 to 1090
• then seller of contract pays buyer (1090 - 1050) x 250 = $10,000
• Using stock index futures contracts
• speculate on stock price movements
• if believe stock index will rise then BUY stock index futures
• if believe stock index will fall then SELL stock index futures
• index fund manager could sell stock index futures to reduce volatility of fund
• if index falls, fund loses value, but futures position gains value
• if index rises, fund gains value, but futures position loses value
• hedging protects against an unfavorable price movement, but also give up benefits of a favorable price movement
• asset allocation
• fund wishes to change mix among stock, bonds, and cash
• actually buying/selling assets trigger transactions costs
• but using stock index futures is less costly
• selling stock index futures decreases stock exposure
• buying stock index futures increase stock exposure
• Treasury Bill futures
• CME, 1975
• 3 month Tbill, $1 million face value
• futures price is price of Tbill for delivery
• quoted as 100 - (discount yield x 100)
• using Tbill futures contracts
• Speculate on interest rate movements
• if believe interest rates will rise (Tbill price fall) then SELL Tbill futures
• if believe interest rates will fall (Tbill price rise) then BUY Tbill futures
• S&L could sell Tbill futures to hedge against rising short term interest rates
• as rates rise, the bond price falls, and the S&L loses money on its spread, but gains with its futures position
• other examples (page 567)