chapter 13 financial futures markets. chapter objectives n explain how financial futures contracts...

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CHAPTER 13 13 Financial Futures Markets © 2003 South-W estern/Thom son Learning

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Page 1: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

CHAPTER

1313 Financial Futures Markets

© 2003 South-Western/Thomson Learning

Page 2: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Chapter ObjectivesChapter Objectives

Explain how financial futures contracts are valued

Explain the use of futures to speculate or hedge based on anticipated interest rate changes

Explain the use of stock index futures to speculate or hedge based on anticipated stock price movements

Describe how financial institutions participate in futures markets

Page 3: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Background on Financial FuturesBackground on Financial Futures

Futures are a derivative security Derivatives

Securities whose value is derived from the value of some underlying asset or financial instrument

Derivative security prices related to factors affecting prices in the spot market

For example, bond futures prices are related to what is happening in markets where bonds are bought and sold for immediate delivery

Page 4: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Background on Financial FuturesBackground on Financial Futures

Standardized agreement to deliver or take delivery of a financial instrument at a specified price and date

Price is determined by traders for standardized contracts The underlying financial instrument Settlement date Form of delivery for underlying asset

Trading on organized exchanges provides liquidity and guaranteed settlement

Page 5: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Background on Financial FuturesBackground on Financial Futures

Exchange members trade contracts in trading pits

Organized exchanges include Chicago Board of Trade and Chicago Mercantile Exchange

Only members or those leasing privileges can transact business on the floor of the exchange Commission brokers Floor traders

Regulated by the Commodities Futures Trading Commission or CFTC

Page 6: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Background on Financial FuturesBackground on Financial Futures

Establish account and initial margin Maintenance margin and margin call Order to trading floor Open outcry trading Clearinghouse function Daily market-to-market of contracts

Steps Involved in Trading Futures

Page 7: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Background on Financial FuturesBackground on Financial Futures

To Speculate Take a position with the goal of profiting from expected

changes in the contract’s price No position in underlying asset

To Hedge Minimize or manage risks Have position in spot market with the goal to offset risk

Purpose of Trading Financial Futures

Page 8: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Interpreting Financial Futures TablesInterpreting Financial Futures Tables

Futures contract prices reported in the financial press

Columns of information for each maturity month that is trading Open, high, low and the settlement or closing

price Change in the closing price from the previous day Open interest or how many contracts are

outstanding for a particular maturity

Page 9: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Valuation of Financial FuturesValuation of Financial Futures

Futures contract price related to the price of the underlying asset

Inverse relationship between debt contract prices and interest rates applies to futures prices

Futures contract price reflects the expected price of the underlying asset or index as of the settlement date

Anything that affects the price of the underlying asset affects the futures price

Impact of opportunity costs or benefits

Page 10: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Bond Futures Contract Price ChangesBond Futures Contract Price Changes

Prices of Treasury bond futures move with spot market

Correlation of price movements in spot and futures important to hedgers and speculators

Market participants in futures monitor the same kinds of economic indicators and interest rate information as Investors who own bonds Investors who expect to buy bonds Borrowers who might plan on issuing debt

Page 11: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Exhibit 13.3 Framework for Futures Exhibit 13.3 Framework for Futures Price Changes Over TimePrice Changes Over Time

RequiredReturn

on TreasuryBond

RequiredReturn

on TreasuryBill

Price ofTreasury

Bond

Price ofTreasury

Bill

ExpectedMovements in

TreasuryBond Prices

Not Embeddedin Existing

Prices

Price ofTreasury

BondFutures

Price ofTreasury

BillFutures

ExpectedMovements in

TreasuryBill Prices

Not Embeddedin Existing

Prices

InternationalEconomicConditions

U.S.FiscalPolicy

U.S.Monetary

Policy

U.S.EconomicConditions

Long-TermRisk-FreeInterestRate

(TreasuryBond Rate)

Short-TermRisk-FreeInterest

Rate(TreasuryBill Rate)

Page 12: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Speculating with Interest Rate FuturesSpeculating with Interest Rate Futures

Long position; purchase futures contracts Strategy to use if speculator anticipates interest rates

will decrease and bond prices will increase Buy a futures contract and if rates drop the contract’s

price rises above what it cost to purchase and exchange adds gain with daily settlement to investor’s account

If interest rates rise instead of fall, futures contract price drops and investor’s account is reduced by daily loss

Page 13: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Exhibit 13.4 Potential Payoff From Exhibit 13.4 Potential Payoff From Speculative Futures PositionSpeculative Futures Position

Profit orLoss fromSellinga FuturesContract

MarketValueof theFuturesContractas of theSettlementDate

S0

Profit orLoss fromPurchasinga FuturesContract

MarketValueof theFuturesContractas of theSettlementDate

S0

Page 14: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Speculating with Interest Rate FuturesSpeculating with Interest Rate Futures

Short position; sell futures contracts Strategy to use if speculator anticipates

interest rates will rise and contract prices drop Sell (short) a futures contract and close the

position by buying a contract to offset short If rates rise, the price to buy the contract and

close the position is less than the price received for the initial sale of the contract

Speculator loses money if rates drop

Page 15: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Closing out the Futures PositionClosing out the Futures Position

Most buyers and sellers of futures contracts do not actually make or take delivery of the underlying asset

Can close position any time before contract expiration date

Offset or close out their positions in the futures market by the settlement date

Trade the same contract and maturity month to open and close the position

Obligations net out when traders close

Page 16: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Closing out the Futures PositionClosing out the Futures Position

Examples Open with the sale of a June maturity T-bill, close

with the purchase of a June maturity T-bill Open with the purchase of a June maturity T-bill

and close with the sale of the same kind of contract and maturity--June T-bill

Gain or loss on a position depends on purchase price compared to the selling price

Daily settlement with exchange

Page 17: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Hedging with Interest Rate FuturesHedging with Interest Rate Futures

Using interest rate futures to create a short hedge

Hedger adversely affected by an interest rate increase Bank using primarily short-term funds to finance

longer-term assets Hurt by rising rates; must refinance funding before

investment re-priced

Page 18: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Hedging with Interest Rate FuturesHedging with Interest Rate Futures

The short hedge Sell futures contracts with characteristics

similar to the securities being hedged If rates increase, hedger closes out the position

at a profit in the futures market to offset spot market position opportunity loss (reduced interest margin)

If rates decrease, hedger’s spot market gains (wider interest margin) offset by losses on the futures position

Page 19: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Hedging with Interest Rate FuturesHedging with Interest Rate Futures

Using interest rate futures to create a long hedge Examples of adverse effects of a decrease in interest

rates Plan to purchase debt securities in a few months and if

rates decline, the purchase price of bonds increases—long futures position locks in price of bonds

Bank finances loans whose rates adjust every six months with CDs that have a two-year term—long futures position locks in loan rates to maintain spread

Hedger uses futures position to offset spot losses and gains—locks in a price or spread

Page 20: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Hedging with Interest Rate FuturesHedging with Interest Rate Futures

Hedging net exposure Futures hedges have transaction costs Net exposure is the difference between asset and

liability positions

Page 21: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Bond Index FuturesBond Index Futures

Bond index futures Muni-bond index futures (MBI) Bond buyers index

Uses of bond index futures to hedge Insurance company using future cash inflows to

buy municipal bond in near future; interest rate decreases will raise bond prices

Investment banking firm underwriting bonds; hurt if interest rates rise, decreasing bond prices

Position to gain in futures if loss occurs in spot

Page 22: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Types of index futures contracts Several different index contracts traded on the

Chicago Board of Trade and Chicago Mercantile Exchange

Securities underlying the contract not deliverable-- cash settlement

Contract’s price is the index times the dollar value given in the contract’s specifications

For example, Chicago Merc S&P contract is the index value times $250

Page 23: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Value of futures contract highly correlated with the value of the underlying index

Differences or advantages and disadvantages to owning the actual index versus futures

Under some circumstances, arbitrage profits are possible

Indicators monitored by the market include anything affecting the underlying index

Page 24: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Speculating with stock index futures Capitalize on expectations without having

sufficient cash to buy the actual stocks in index Expect an increase in stock prices, buy index

futures; gain/losses leveraged with small investment

Hedging with stock index futures Hedge market risk of an existing portfolio Pension fund manager with reasonable return for

year sells index futures contracts to lock in return

Page 25: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Hedging issues Hedge is more effective if investor’s portfolio is

diversified like the the underlying index for the futures contract

Portfolio managers do not necessarily hedge the entire portfolio

Dynamic asset allocation with stock index futures Portfolio manager uses stock index futures to vary

risk/return position of portfolio without restructuring existing stock portfolios

An efficient risk management technique

Page 26: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Prices of stock index futures versus stocks Differ to some degree Index futures prices may be higher or lower than

the underlying index Stock index futures can more rapidly change as

expectations change—investors watch as indicator of market direction

Differentials reduce hedging effectiveness Test of suitability of stock index futures

Page 27: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Arbitrage with stock index futures Institutional investors capitalize on differences

between price of index futures and stock prices Simultaneous buy/sell program trading when there

is a profitable difference between index futures and stocks represented in the underlying index

Serves to “tie” the index value to that of the corresponding stock portfolio used by other investors to hedge or speculate

Page 28: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Stock Index FuturesStock Index Futures

Circuit breakers on stock index futures Suspends trading on specific stocks or stock

indexes after a specified market decline Gives investors a chance to evaluate information

or meet margin calls before trading resumes Impacts program trading which has been linked to

market volatility

Page 29: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Risks of Trading Futures ContractsRisks of Trading Futures Contracts

Market risk Speculators win or lose based on changing market

value of futures contracts Hedgers, with a position in the underlying asset,

are not significantly impacted by contract price volatility

Basis risk Futures contract prices do not vary in exactly the

same way as the underlying asset’s price Price correlation of contract and underlying asset

impacts the ability to hedge market risk

Page 30: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Risk of Trading Futures ContractsRisk of Trading Futures Contracts

Dealing with basis risk Identify futures contract with price changes

closely related to the underlying asset Cross hedging involves using a futures contract

with an underlying asset different from the asset to hedge, for example, hedge commercial paper rate exposure with T-bills futures

Liquidity risk Price distortions if a contract is not widely traded Need a counterparty to close position

Page 31: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Risk of Trading Futures ContractsRisk of Trading Futures Contracts

Credit risk Counterparty defaults Not a risk on exchange-traded contracts where

exchange serves as the counter-party Prepayment risk

Assets (e.g. loans) prepaid sooner than their designated maturity

Leaves hedger without an offsetting spot position in a speculative position

Page 32: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Risk of Trading Futures ContractsRisk of Trading Futures Contracts

Operational risk Inadequate management or controls For example, hedging firm’s employees do not

understand how futures contract values respond to market conditions

Lack of controls may result in speculative positions

Page 33: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Regulation in the Futures MarketsRegulation in the Futures Markets

More awareness about systemic risk given recent events in the markets

Problems at one firm can affect other firm’s ability to honor contractual agreements

Regulators want participants to have sufficient collateral to back their positions

Accounting regulators goal is disclosure so risks are clear

Page 34: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Institutional Use of Futures MarketsInstitutional Use of Futures Markets

Most activity is for hedging, not speculating Many kinds of institutions uses futures

Commercial banks Savings institutions Securities firms Mutual funds Pension funds Insurance companies

Page 35: CHAPTER 13 Financial Futures Markets. Chapter Objectives n Explain how financial futures contracts are valued n Explain the use of futures to speculate

Globalization of Futures MarketsGlobalization of Futures Markets

Non-U.S. participation in U.S. futures contracts

Foreign stock index futures on foreign stock indexes and markets

Financial futures also available for selected foreign debt instruments

Currency futures contracts for few large country currencies