17-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian.

17-1

Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by PeirsonSlides prepared by Farida Akhtar and Barry Oliver, Australian National University

Chapter 17

Futures Contracts

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Learning Objectives

• Understand what a futures contract is and how futures markets are organised.

• Understand the system of deposits, margins and marking-to-market used by futures exchanges.

• Understanding the determinants of futures price.

• Understand that speculation and hedging with futures contracts may be imperfect.

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Learning Objectives (cont.)

• Understand and explain the features of the major financial futures contracts traded on the Australian Securities Exchange (ASX).

• Explain speculation and hedging strategies using the major financial futures contracts traded on the ASX.

• Understand the valuation of 90-day bank-accepted bill futures contracts and share-price index futures contracts.

• Understand and explain the uses of forward-rate agreements (FRAs).

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Futures and Forward Contracts• A futures contract is an agreement that provides

that something will be sold in the future at a fixed price.

• The price is decided today, but the transaction is to occur later.

• Australian futures contracts are traded on the Australian Securities Exchange (ASX).

• A forward contract will have the following features:– The forward price is decided now, but the transaction is

to occur on a nominated future date.

– The details of the commodity, which are the subject of the contract, are spelt out.

– The contract is a private contract between you and me.

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Characteristics of Futures Market

• Standardised contract sizes and maturity dates.

• Clearing house guarantees performance of all contracts, both buyers and sellers.

• Futures contracts require you to put up deposits and satisfy margin calls if required.

• Buyers and sellers do not need to know the identity or credit worthiness of other buyers and sellers.

• Note ‘short selling’ is possible.

• Contracts usually closed out (by taking offsetting position) at or before maturity rather than physically delivered.

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Deposits, Margin Calls and the Mark-to-Market Rule

• Deposits

– All traders are required to open an account and deposit a specified amount of money with the clearing house before entering into first contract.

– Mark-to-market.

– The clearing house adjusts the recorded value of an asset to its market price on a daily basis.

• Margin calls

– A requirement that extra funds be deposited as a result of adverse price movements in the price of a contract.

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The Australian Securities Exchange (ASX)• Opened for trading in 1960, was then called Sydney

Greasy Wool Futures Exchange — reflecting the importance of the commodity (agricultural) futures at that stage.

• ASX operates own clearing house to:– Establish and collect deposits.– Call in margins.– Apportion the gains and losses.

• Some of the trading on the ASX include:– 90-day bank-accepted bills.– 3-year and 10-year Australian Treasury Bond.– Standard & Poors, ASX 200 (SPI200).– 30-day inter-bank cash rate contract.– Australian dollar.– Options on futures contracts.

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Determinants of Futures Prices• Futures pricing theorem

– The futures price for a late-delivery contract must be less than (or equal to) the futures price for an equivalent early-delivery contract, plus the carrying cost.

– The carrying cost is the cost of holding a commodity from one time period to another.

It includes an interest factor (opportunity cost of funds used to finance the holding of the commodity) and, in the case of physical commodities, the costs of insurance and storage.

– A futures price must be less than (or equal to) the current spot price plus the carrying cost.

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Determinants of Futures Prices (cont.)

Algebraically, it is written as:

• The maximum value that the expected spot price, E(S), can be, given the current spot price, S, the carrying cost, C, and a risk factor is given by:

• If there is a big difference between the expected spot price and futures price, it may reflect an arbitrage opportunity, depending on perceptions about the risk factor.

risk factorE S S C

F S C

where:

futures price

current spot price

carrying cost

F

S

C

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Futures Market Strategies: Speculating and Hedging• Speculator: someone who has traded in a futures

contract but who has no direct interest in the ‘commodity’ underlying the futures contract.

– Affected by the futures price (but not the spot price) of the commodity.

– By trading in futures contracts, speculators are exposed to the risks of changes in the futures price — a risk to which they would not otherwise have been exposed.

• Speculation — case study:

– Barings Bank — futures speculation gone wrong.

– Soceite Generale — allegedly unauthorised trading.

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Futures Market Strategies: Speculating and Hedging (cont.)• Hedger: someone who has traded in a futures contract

and has a ‘genuine’ interest in the ‘commodity’ underlying the futures contract.

– Affected by both the futures price and the spot price of the commodity.

– The hedger is exposed to the risk of changes in the futures price, but only in an attempt to offset the pre-existing risk of changes in the commodity price itself.

• Hedging — case study:

– Metallgesellschaft — case apparent hedging strategy that went terribly wrong.

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Speculating

• In the simplest case, a speculator hopes to:

– Take a long position (i.e. buy) when the futures price is ‘low’, reversing out (i.e. selling later) when the futures price has increased; and/or

– Take a short position (i.e. sell) when the futures price is ‘high’, reversing out (i.e. buying later) when the futures price has decreased.

• In either case, the speculator gains. However, if the opposite occurs, the speculator loses.

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Speculating (cont.)• Scalping:

– Scalpers try to develop a continuously updated ‘feel’ for the market, anticipating and exploiting perceived short-term excesses of supply or demand.

• Spreading:

– A ‘spread’ is a long (bought) position in one maturity date, paired with a short (sold) position in another maturity date.

• Day trading:

– Day traders are prepared to trade as they see fit during a trading day, but regard an overnight position as too risky.

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Speculating (cont.)

• Long-term/overnight position taking:

– The simplest and riskiest type of speculation.

– Speculators form a view that the current futures price is too low (or too high), trade accordingly, and wait for events to prove them right.

• Straddling:

– A ‘straddle’ is similar in concept to a spread but refers to positions in futures contracts on different commodities.

– For example:

A speculator might buy a March bank bill contract and sell a March bond contract.

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Hedging

• Example

– A grazier intends to sell his cattle in several months’ time.

– He is affected by movements in the spot price of cattle:

Gaining if it increases (his cattle become more valuable).

Losing if it decreases (his cattle become less valuable).

– To be protected against these changes, he can sell cattle futures, that is, he becomes a short hedger.

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Hedging (cont.)

Short hedging outcomes

IF PRICES RISE IF PRICES FALL

Short futures contract Loss Gain

Cattle - spot Gain Loss

Net result Approximately zero Approximately zero

• Short hedger– Someone who hedges by means of selling futures

contracts today (going short).

Table 17.3

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Hedging (cont.)• Long hedger

– Someone who hedges by means of buying futures contracts today (going long).

Table 17.4

Long hedging outcomes

IF PRICES RISE IF PRICES FALL

Long futures contract Gain Loss

Cattle - spot Loss Gain

Net result Approximately zero Approximately zero

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Some Reasons Why Hedging with Futures is Imperfect• Imperfect convergence

– The price of a futures contract with zero time to maturity ought to be equal to the spot price.

– However, in reality the futures price at maturity can be slightly different from the spot price. The convergence between the spot and futures price as the maturity date approaches can be imperfect.

– Although this convergence will be imperfect, it may not be possible to profit from this difference due to transaction costs.

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Some Reasons Why Hedging with Futures is Imperfect (cont.)• Basis risk

– A hedger will plan to transact in the spot market at some future date. However, it is usual for the planned spot transaction date to coincide with the maturity date.

– When the dates do not coincide, the hedger must reverse out of the futures contract before it matures and faces ‘basis risk’.

– Basis: the spot price S at a point in time minus the futures price F (for delivery at some later date) at that point in time.

– At time zero the basis B is: B (0) = S (0) – F (0)

– At time 1 the basis B is: B (1) = S (1) – F (1)

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Some Reasons Why Hedging with Futures is Imperfect (cont.)

• Consider a short hedger: makes a gain (loss) on the futures contract if the futures price decreases (increases), and a gain (loss) on holding the commodity if the spot price increases (decreases).

• Specification differences:

– Refers to the fact that the specification of the ‘commodity’ that is the subject of the futures contract may not precisely correspond to the specification of the ‘commodity’ that is of interest to a hedger.

Total gain to short hedger = gain made on futures

+ gain made on spot

[ (0) - (1)] [ (1) - (0)]

[ (1) - (1)] - [ (0) - (0)]

(1) - (0)

change in basis b

F F S S

S F S F

B B

etween Time 0 and Time 1

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Selecting the Number of Futures Contracts• Suppose that a hedger has an interest in NS units of a

‘commodity’. If this interest is a long (short) position, then NS is positive (negative).

• The optimum number of futures contracts f * is:

* 0

0

s

f

N Sf

N F

0

0

where:

spot price per unit when the hedge is entered(today)

futures price per unit when the hedge is entered(today)

number of units of the commodity covered by each futures contractf

S

F

N

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The Bank Bill Futures Contract

• Contract specifications for 90-day bank-accepted bills:

– Contract unit — 90-day bank-accepted bill with a face value of $1m.

– Delivery months — Mar, June, Sept, and Dec up to 3 years out.

– Delivery day — first business day after last trading day.

– Quotations — 100 minus annual percentage yield to two decimal places.

– Settlement — cash or physical settlement.

– Settlement date — the second Friday of the delivery month.

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Hedging with Bank Bill Futures• Annamay Ltd needs to borrow in 2 weeks’ time by

issuing a 90-day bank bill with a face value of $1m. Currently, bank bill rate is 4.4%.

• Risk: that the bill rate would increase; therefore, the company decided to protect itself by selling one BAB futures contract at 95.78 (4.22%).

• Scenario

– During the next 2 weeks, the 90-day bill rate increased and the bill was issued at 5.5%. At this date the BAB futures contract was priced at 94.70 (5.3%).

– Question: What is the result of this course of action?

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Hedging with Bank Bill Futures (cont.)• Physical market

1mplanned borrowing: = $989267.13

[1 + (90 x 0.044/365)]

1mactual borrowing: = $986619.81

[1 + (90 x 0.055/365)]

Dollar shortfall (gross) = $989267.13 - $986619.81

=$2647.32

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Hedging with 90-day Bank Bills

• Futures market

• Hedge reduces shortfall from $2647.32 to $45.73 (a reduction of 98.3%).

1msell 1 bank bill futures: =$989,701.68

[1 + (90 x 0.0422/365)]

to close futures position, buy 1 bank bill futures:

1m=$987,100.09

[1 + (90 x 0.053/365)]

Result from futures = $2601.59 (gain)

Net dollar shortfall = $ 2647.32 - $2601.59

= $45.73

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10-year Treasury Bond Futures Contract• Contract specification

– Contract unit — 10-year government bond with a face value of $100 000 and a coupon rate of 6% p.a.

– Settled by cash, not delivery.

– Quotations — 100 minus the annual percentage yield.

• Uses

– Can be used in ways similar to those explained for the bank bill contract.

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The 30-day Interbank Cash Rate Futures Contract• The 30-day interbank cash rate futures contract is

similar to bank bill contract, which is suitable for speculation, hedging and arbitrage in short-term interest rates.

• Major features of 30-day interbank cash rate futures contract include:

– Contract Unit.

– Settlement.

– Quotations.

– Termination of Trading.

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Share Price Index (SPI 200) Futures Contract• Specifications

– Contract unit: value of the S&P/ASX 200 Index, multiplied by $25.

– Settlement: not deliverable, closed out at the close of trading at the relevant spot index value, calculated to one decimal place.

– Quoted as the value of the S&P/ASX 200 Index (to one full index point).

• Example 17.13

– On 23 January 2008, the S&P/ASX 200 Index closed at 5412.3 and the March (2008) SPI200 futures price was $5379.

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Speculation with the SPI Futures (cont.)

– Suppose that a speculator believes that share prices are likely to rise in the following 2 weeks and, therefore, decides to buy March SPI200 futures.

– On 30 January 2008, the S&P/ASX 200 Index has risen to 5618.7, and the March SPI futures price has risen to $5589.

• The total gain can be calculated as follows:

Notional sale at: 5379 x $25 = $134 45 (outflow)

Notional purchase at: 5589 x $25 = $139 725 (inflow)

Gain (net inflow): $5 250 _

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Hedging with SPI Futures

• Example 17.14

– Michael Saint manages a portfolio of Australian shares with a current market value of $1 510 700.

– The portfolio is to be sold in 4 weeks’ time.

– The SPI 200 futures price today is 5421.

– Assume that proportionate changes in the portfolio’s value will be matched by proportionate changes in the futures price.

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Hedging with SPI Futures (cont.)

Number of futures contracts needed to hedge the portfolio:

* 0

0

value of spot positionvalue of one futures contract

$1 510 70005421X$25111.47

s

f

NSf

NF

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Hedging with SPI Futures (cont.)

SPI FUTURES PRICE SPI FUTURES PRICE PORTFOLIOPER CONTRACT FOR 28 CONTRACTS VALUE

DATE (INDEX FORM) ($) ($)

When hedge entered 5421 (sold) 15 043 275 15 107 000

When hedge lifted 5159 (bought) 14 316 225 14 444 500

Gain (loss) 727 050 (662 500)

Table 17.11

Therefore, the hedge has, in fact, resulted in a net gain of:

$727 050 – $662 500 = $64 550

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Valuation of Financial Futures Contracts

• A restriction on the valuation of futures contract is given by:

• If the commodity can readily be sold short, and if the opportunity cost of investment is the only form of carrying cost, then:

F S C where:

futures price

current spot price

carrying cost

F

S

C

F S C

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Valuation of Bank Bill & SPI Futures Contracts• The bank bill futures price is simply the spot price of the

relevant bank bill, accumulated at the yield applicable to the term of the futures contract.

The valuation of the SPI futures contract is slightly more complex, because dividends are paid on many shares in the index but the calculation of the SPI excludes dividends.

1F S PV D r

1 tF S i

where:

present value of the dividends

futures price

current spot price

PV D

F

S

17-35


Forward-Rate Agreements (FRAs)• An agreement to pay or receive a sum of money

representing an interest differential, such that the interest rate applicable to a specified period is fixed.

• Typically a private arrangement that cannot be traded on a secondary market.

• Usually, at least one of the parties to an FRA will be a bank or some other financial institution.

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Example of an FRA• Company A intends to borrow $1m in 3 months, to

be repaid in a lump sum 180 days later. • Present interest rate on 180-day loan is 9.4%.• Company A approaches Bank B to set up a forward

rate agreement. • Bank B does this at 9.5%. • At the FRA settlement date the market interest rate

is 10.25%.• Settlement amount is the difference between the

present value of $1m discounted at the contract rate and the present value of $1m discounted at the current market rate (differential: $3363.11).

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Summary• Futures: Obligation to deliver/receive a physical or

financial commodity at a future date.• Futures markets are based on a clearing house,

system of deposits, marking to market and margin calls.

• Futures prices depend on the spot price, carrying costs and cost of uncertainty or the risk factor.

• Futures can be used for hedging or for speculation. However, it may not provide perfect hedging or speculative features: basis risk, specification differences and imperfect convergence.

• Forward-rate agreements are similar to futures and offer an alternative means of risk management when futures do not exist.

17-1 Copyright 2009 McGraw-Hill Australia Pty Ltd PPTs t/a Business Finance 10e by Peirson Slides prepared by Farida Akhtar and Barry Oliver, Australian.

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