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CHAPTER 13
Financial Future Markets
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Derivatives
A derivative transaction involves no actual transfer of
ownership of the underlying assets at the time the
contract is initiated. A derivative represents an
agreement to transfer ownership of underlying assets
at a specific place, price, and time specified in the
contract. Its value (or price) depends on the value of
the underlying assets.
The underlying assets: stocks, bonds, interest rates,
foreign exchanges, index, commodities, some
derivatives, etc.
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Main Types of Derivatives
 Forward
 Futures
 Options
 Swaps
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Forwards
An agreement between two parties to exchange
cash for a commodity or financial asset at some
specific time in the future at a predetermined price.
1. Terms
are unique to each individual forward
contract. That is, each contract is customized.
2. There is a risk that one side might default on its’
obligation.
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Forwards
Example:
Cotton is now traded at $1000 per ton in spot
market. You would like to purchase one ton
and receive it 111 days from today. You
would like to enter into a “forward contract”.
I am willing to accommodate you in this
desire. Now we must agree on the forward
price that you must pay me after 111 days
and how the commodity is delivered.
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Futures
A standardized “forward contract” traded on an
organized and regulated futures exchange.
1. Futures contracts are guaranteed by the exchange’s
clearinghouse that eliminates the risk of contra-party
default.
2. Each contract is standardized on the quantity,
quality, delivery place, delivery date, contract
expiration date.
3. A deposit called “margin” is required to both buyers
and sellers.
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Forwards vs. Futures
1. Futures contracts trade on an organized exchange.
2. Futures positions can be closed or transferred
3.
4.
5.
6.
easily.
Futures contracts have standardized terms (quantity,
expiration, etc.)
Futures contracts are guaranteed by the
clearinghouse associated with the exchange.
Futures are subject to daily settlement (marked to
the market).
Margin is required to both the buyer and seller.
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Options
A contract that is associated with a right to buy or
sell a commodity or financial assets until a specific
date with a predetermined price and amount, etc.
There are Call options and Put options.
1. The buyer of a Call option has the right, not the
obligation, to buy an asset.
2. The buyer of a Put option has the right, not the
obligation, to sell an asset.
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Swaps
An agreement between two parties to
exchange sequences of cash flows over a
period in the future.
Example: exchange of a fixed rate of interest
for a floating rate of interest.
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Application of Derivatives
 Hedging and risk management
 Speculation
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Futures markets
 Originated for trade of agricultural
commodities
 Financial futures has a history of about 30
years.
 Four main categories (physical commodities,
foreign exchange instruments, interestearning assets, stock indices)
 Long vs. Short positions
Main Futures Exchanges
 Chicago Board of Trade (CBT): futures on T-
bonds and agricultural products.
 Chicago Mercantile Exchange (CME): futures
on money market securities, stock indexes,
and currencies.
Standardized Contract Terms
Example: a CBT wheat Futures contract
 Quantity: 5,000 bushels
 Commodity type: No.2 Soft Red, etc.
 Expiration: July, September, December,
March, and May
 Delivery place: in a warehouse approved by
CBT
 Minimum price change (tick size): 0.25 cents
per bushel or $12.50 per contract.
Clearinghouse
 Guarantees that all traders in the futures
markets will honor their obligations.
 Act in a position of buyer to every seller and
seller to every buyer. So no default risk as a
counter-party to every trader.
Goods
Buyer
Goods
Clearinghouse
Funds
Seller
Funds
Margin and Daily Settlement
 Initial margin (5-18% of the underlying asset’s value)
 Maintenance margin
 Marking to market: realize any loss or profit in cash
every day.
Example: Long an oat future in CBT, 5000 bushels,
initial margin is $1,400, maintenance margin is
$1100.
day
1
2
3
Price (cent/bushel) Contract value ($) Profit/Loss ($) Margin value ($)
171
8,550
0
1,400
168
8,400
-150
1,250
164
8,200
-200
1,050
Margin Call
Closing a Position
 Delivery
 Offset – reverse trade
 Cash settlement: make payment at expiration date to
settle any gains or losses, instead of making physical
delivery.
Types of Futures
 Commodities: wheat, oat, cotton
 Foreign currencies: euro, British pound,
Canadian dollar, Japanese yen.
 Interest-earning assets: Treasury notes and
bonds, Eurodollar deposits
 Indexes: S&P500, Dow Joes, NASDAQ 100
 Individual stocks, e.g., IBM.
Participants in Futures Markets
 Hedgers: hedging, risk management
 Speculators: make money by taking risk
 Brokers: receive commission fee
 Regulators: futures exchanges and
clearinghouses, the National Futures
Association, the Commodity Futures Trading
Commission
Different Interest Rate Futures
Treasury Bill Futures
 Trading cycles: Mar/Jun/Sep/Dec
 the underlying: the $1 million T-bill with 90-day
maturity.
 No actual delivery, cash settlement.
 quotation: CME IMM index = 100.00 – Discount Yield
Exhibit 13.1 Example of Treasury Bill Futures
Quotations
T-bill Futures Example 1(p.340)
Jim Sanders purchased a T-bill futures with
the price of 94.00 (a 6% discount) and that
the price as of the March settlement date is
94.90 (a 5.1 % discount). What is the profit
from the trade?
94.9%x1,000,000-94.00%x1,000,000=9,000
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T-bill Futures Example 2
Jim Sanders purchased a T-bill futures with
the price of 94.00 (a 6% discount) and that
the price as of the March settlement date is
92.50 (a 7.5 % discount). What is the profit
from the trade?
92.5%x1,000,000-94.00%x1,000,000=-15,000
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T-Bond Futures (maturity is over 10 years)
Treasury Bond Futures (quotation on page 345)
 Trading cycles: Mar/Jun/Sep/Dec
 Quotations in points and 32nd of par. e.g., 97-26
(97.8215)
 Underlying: $100,000 worth (face value) of
deliverable T-Bonds
 Cash settlement or delivery
 Tick size is 1/32nd of 0.01
(1/32x0.01x$100,000=$31.25)
T-bond Futures Example 1(p.341)
A speculator purchased a futures on Treasury
bond at a price of 90-00. One month later, the
speculator sells the same contract at 92-10.
given the par value of the contract is
$100,000, what is the profit?
(92+10/32)x0.01x100,000 - (90+00/32)0.01x100,000
=2,312.50
Interest Rate and Futures Price
General rule for interest rate futures price:
 If interest rates are expected to go up, the
price of interest rate futures will go down, and
vice verse.
T-bond Futures Example 2
You are managing an existing long-term
bond portfolio. If you expect higher long-term
interest rates in the future, how can you
hedge your bond portfolio against the
interest rate risk?
Charlotte Insurance (page 342).
Stock Index Futures Contracts
 Main stock index futures (Exhibit 13.7, p347)
See next slide
 Features:



Cash settlement
Trading cycle (March, June, September,
December)
Different contract dollar multipliers
 Quotations for stock index futures. (page 348)
Exhibit 13.7 Stock Index Futures Contracts
Stock Index Futures Example 1
The spot S&P500 index is 1300. Boulder Insurance
company plans to purchase a variety of stocks for its
stock portfolio in December. It anticipates a large
jump in stock market before December. The futures
price on the S&P500 index with a December
settlement date is 1500. The value of an S&P500
futures contract is $250 times the index. If the
S&P500 index rises to 1600 on the settlement date,
what is the profit if the company buy one future now?
1600x250-1500x250=$25,000
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Stock Index Futures Example 2
Assume that a portfolio manger has a well diversified
stock portfolio valued at $2,000,000. Also assume
that S&P500 index futures contracts are available for
a settlement date one month from now at a level of
1600, which is equal to today’s index value. How
does the manager do to hedge the stock portfolio?
Sell futures. $2,000,000/(1600x$250)=5 contracts
If market goes down by 5%, then …
If market goes up by 5%, then …
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Single Stock Futures
a. A contract to buy or sell a single stock
(usually 100 shares)
b. Settlement dates are quarterly
c. Offer potentially high returns (with high
risk)
d. Closing out involves taking opposite
position anytime before settlement date
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Institutional Use of Futures Markets
1.
2.
3.
4.
5.
6.
Commercial banks
Savings institutions
Securities firms
Mutual funds
Pension funds
Insurance companies
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Exhibit 13.10 Institutional Use of Futures Markets
Homework Assignment 8
 Problems: 1 2 3 4 5 6 7
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