Chapter 14

Futures Contracts

Forward Contract

Agreement made today between buyer and

seller
Both are obligated to complete a transaction
at a date in the future
Buyer and the seller know each other
Customized agreements are negotiated

All contract terms can be customized to the

requirements of the buyer and seller

14-2

Forward Contract

Forward Price

Default Risk

Price at which the trade will occur

Determined when the agreement made

Counterparty may have incentive to default on the contract

To cancel the contract, both parties must agree

Cancellation payment may be required

14-3

Futures Contract

Agreement made today between buyer and seller

Both obligated to complete a transaction at a date in
the future.
Buyer and the seller do not know each other.

Any "negotiation" occurs in a futures pit.

Standardized contract terms

What to trade; Where to trade; When to trade; How

much to trade; what quality of good to tradeall
standardized under the terms of the futures contract.
14-4

Futures Contract

Futures Price

No default risk

Price at which the trade will occur

Determined "in the pit"

Futures Clearing and the exchange guarantees each trade

Offsetting trade "in the pit" cancels a contract

Trader may experience a gain or a loss

14-5

Forward & Futures Contracts

Both:

Are a firm commitment by both buyer and

seller
Specify a price today for a future
transaction
Specify a delivery date
Clearly define what is to be delivered and
where
14-6

Forward & Futures Contracts

BUT:

Forward contracts:

Between a specific buyer and seller who remain

linked throughout the life of the contract
Counterparties have negotiated an exact
delivery date and terms

Futures contracts:

Fundamentally standardized, exchange-traded

forward contracts.
14-7

Organized Futures Exchanges

Chicago Board of Trade (CBOT)

Established in 1848
Oldest organized futures exchange in US

CME Group

CME (1874) and CBOT merge 2007

CME and NYMEX (1872) merge 2008

In 2007, the Intercontinental Exchange (ICE)

purchased the New York Board of Trade (NYBOT)

Originally all traded storable agricultural commodities

(soybeans, corn, wheat)
14-8

Financial Futures

Important milestones:

Currency futures trading

Gold futures trading

December 31, 1974

= day ownership of gold by U.S.

citizens legalized.
U.S. Treasury bill futures
U.S. Treasury bond futures
Eurodollar futures
Stock Index futures

1972
1974

1976
1977
1981
1982

Today, financial futures = bulk of all futures trading.

14-9

Futures Contract Terms

Five basic terms:
1.

2.
3.
4.
5.

Identity and description of the

underlying commodity or financial
instrument
Contract size.
Maturity or expiration date
Delivery or settlement procedure
Futures price
14-10

Futures Prices in the Wall Street Journal

14-11

Futures Prices on the Web

14-12

Futures Price Quotes

Cocoa futures

Traded on the NY Board of Trade (ICE)

Contracts: March, May, July, September, December
Contract Size: 10 tonnes (metric tons) = 22,046 lbs
Price quote: $ per metric ton

COCOA (NYBOT) 10 metric tons $ per ton.

Source: WSJ 07/02/2008

14-13

Why Futures?

Futures contract = zero-sum game

Buyers gains = sellers losses

Futures exchanges track daily gains/losses

Marking to market

Hedging and Speculation

Hedging and speculating = complementary

Hedgers shift price risk to speculators
Speculators absorb price risk
14-14

Speculating with Futures: Long

Buying a futures contract:

= establishing a long position

= going long

Profit and Loss from a Speculative Long Position

Every day a new futures price is established.

If new price > previous days price

Long position profits

If new price < previous days price

Long position loses

14-15

Speculating in Gold Futures

You believe the price of gold will go up.

You go long 100 futures contracts that expire in 3 months.

Gold futures price today = $800 per ounce.
Gold futures contract = 100 ounces

Position value" = $800 100 100 = $8,000,000

If the price of gold is $820 when the futures

contract expires:

Position value = $820 100 100 = $8,200,000

Long speculation gain = $200,000

14-16

Speculating with Futures: Short

Selling a futures contract:

= establishing a short position

= going short

Profit and Loss from a Short Speculative

Position

Every day before expiration, a new futures price is

established.
If new price > previous days price
Short position loses
If new price < previous days price
Short position profits
14-17

Speculating in Gold Futures

You believe the price of gold will go down.

You go short 100 futures contracts that expire in 3 months.

Futures price today = $800 per ounce.
Gold futures contract size = 100 ounces

Position value = $800 100 100 = $8,000,000

If the price of gold is $770 when the futures contract

expires:

Position value now = $770 100 100 = $7,700,000

Short speculation gain = $300,000

14-18

Hedging with Futures

A hedger trades futures contracts to transfer price

risk.

Hedgers transfer price risk by adding a futures

contract position that is opposite of an existing
position in the commodity or financial instrument.

When the hedge is in place:

The futures contract throws off cash when cash is

needed.
The futures contract absorbs cash when cash is available.

14-19

Hedging

Hedging = doing NOW in the futures market

what you will have to do in the future in the
cash market in order to transfer your risk.
Hedger = a natural in the market

The farmer plants in the spring

He must sell into the cash market at harvest time
in the fall.
He can hedge his risk by selling into the futures
market now.
14-20

Natural Long and Short Hedges

The farmer who plants soybeans in the

spring will need to sell in the fall.

He is a natural long.
To hedge his risk, he needs to go short in
the futures market.
He sells his expected crop output now to
transfer his risk

14-21

Natural Short and Long Hedges

A cereal maker needs a continuous

supply of grains.

He is a natural short.
To hedge his risk, he needs to go long in
the futures market.
He buys futures contracts now to lock in
his futures costs.

14-22

Hedging with Futures: Short Hedge

A company has a large inventory that will

be sold at a future date.
The company will suffer losses if the
value of the inventory falls.
To protect the value of their inventory:

Selling futures contracts today offsets

potential declines in the value of the inventory.
Selling futures contracts to protect against
falling prices is called short hedging.

14-23

Short Hedging with Futures Contracts

Starbucks has 950,000 pounds of coffee in inventory,

valued at $0.57 per pound
Starbucks fears coffee prices will fall in the short run
Data:
NYBOT trades coffee futures contracts
Each contract is for 37,500 pounds of coffee
Coffee futures price with three month expiration =
$0.58/lb
Selling futures contracts provides current inventory
price protection
25 futures contracts covers 937,500 pounds
26 futures contracts covers 975,000 pounds
14-24

Short Hedging with Futures Contracts

Starbucks sells 25 near-term futures

contracts.

Over the next month:

Price of coffee falls

Starbucks sells its inventory for $0.51/lb
Futures price also falls to $0.52

How did this short hedge perform?

14-25

The Short Hedge Performance

The hedge was not perfect.

Short hedge threw-off cash ($56,250) which offset
the decline in the inventory value ($57,000).

What would have happened if prices had increased by $0.06 instead?

14-26

Long Hedging with Futures

A company needs to buy a commodity at a

future date.

To "fix" the price theyll pay:

Buying futures contracts today offsets
potential increases in price
Buying futures contracts to protect against
rising prices is called long hedging
14-27

Long Hedging with Futures Contracts

Nestles plans to purchase 750 metric tons of

cocoa next month.
Current cocoa prices = $3,400 per tonne
Nestle fears the price will increase before next
month and wants to lock in the price it will pay
Data:

NYBOT trades cocoa futures contracts

Contract size = 10 metric tons (22,046 lbs)
Cocoa futures price with three months to expiration =
$3,440 per tonne
Buying futures contracts locks in acquisition price
75 futures contracts covers 750 metric tonnes
14-28

Long Hedging with Futures Contracts

Nestles decides to buy 75 near-term

futures contracts.
Over the next month:

The price of cocoa increases to $3,490.

The futures price increases to $3,525.

How did this long hedge perform?

14-29

The Long Hedge Performance

This is a reference price to show
the difference in what will be paid.

Date

Nestles
Cocoa
Price

Nestles
Inventory
Acquisition

Near-Term
Cocoa
Futures
Price

Value of 75
Cocoa
Futures
Contracts

Now

$3,400

$2,550,000

$3,440

$2,580,000

1-Month
From now

$3,490

$2,617,500

$3,525

$2,643,750

Gain (Loss)

$90

$67,500

$85

$63,750

The hedge was not perfect. But, the long hedge threw-off cash
($63,750) when Nestles needed some extra cash to offset the
increase in the cost of their cocoa inventory acquisition ($67,500).
What would have happened if cocoa prices fell by $85 instead?
14-30

Hedging Currency Transactions

Your company has contracted to buy products

from Japan in three months for 2 million yen.

Todays exchange rate =105.99 to the US$

2 million yen = $18,869.70

Looking at the forward rates, you fear prices will

move against your company in 3 months.

Is your company short or long yen?

How would you hedge your companys exposure
to possible changes in the US$-Yen exchange
rate?

14-31

Hedging Currency Transactions

Company is short; they will need to buy Yen in 3

months.
With the quotes shown above, 2 million yen would
currently = $18,869.70. (2,000,000/105.99)
At the 3-month forward rate 2 million yen = $18,969.93.
Entering into a 3-month forward contract for 2 million
yen at the above rate will lock in the exchange rate.
14-32

Hedging Currency Transactions

Suppose the situation is reversed:

In 6 months your company will receive 4 million

yen for product you will deliver.

How do you hedge your exposure?

14-33

Hedging Currency Transactions

Your company has a long position in Yen youre going to

receive Yen in 6 months.
Now 4 million Yen = $37,739.41.
If spot rates move as expected, youll be OK.

In 6 months, 4 million Yen will result in $38,153.38.

You can lock in that price now by shorting a 6-month forward

contract in Yen at the rate of 104.84 Yen per US$.
14-34

Futures Trading Accounts

Margin required

Initial margin

Level depends on the price volatility of the underlying

asset

Can differ by type of trader

Maintenance margin

A futures position can be closed out at any time by

entering a reverse trade.

In the hedging examples, Starbucks and Nestles entered

reverse trades at the time they adjusted inventories.

14-35

Marking to Market

Daily adjustment of a futures trading

account value based on market
settlement price (closing price)

If balance < maintenance margin margin

call
Margin call = demand by broker for more
money to be deposited into the trading account.

14-36

Margin and Marking to Market

Molly believes gold prices will increase.

She takes a long position in gold futures.

Her broker requires:

Futures price = $400 per oz

Initial margin of $1,000 per contract
Maintenance margin of $750 per contract

Molly deposits $1,000 into her trading account.

Note: A reputable brokerage firm would actually
require more, perhaps as much as $10,000.
14-37

Mollys Trading Account for a Long

Position in One Gold Futures Contract
Day Deposits

Closing
Futures
Price

$1,000

Equity
Value of
Account

Maint.
Margin
Level

Diff.

Action
Initial
Margin
Deposit

$1,000

$750

+$250

$400

$1,000

$750

+$250 Molly buys

$398

$800

$750

+$50

3
4

$600

at close

$394

$400

$750

-$350

$394

$1,000

$750

+$250

Margin
Call for
$600

14-38

Cash Prices

Cash price:

= spot price
= price for immediate delivery.

Cash market = spot market

Where commodities or financial instruments are

traded for immediate delivery.

Immediate" delivery can be 2 or 3 days later.

14-39

Quoted Cash Prices

14-40

Cash-Futures Arbitrage

Earning risk-free profits from an unusual

difference between cash and futures prices is
called cash-futures arbitrage.

In a competitive market, cash-futures arbitrage

has very slim profit margins.

Cash prices and futures prices are seldom

equal.

14-41

Cash-Futures Arbitrage

Basis = Cash price Futures price

Carrying charge market :
Basis = Cash price Futures price < 0
Commodities with storage costs
Inverted market:
Basis = Cash price Futures price > 0

Basis is kept at an economically appropriate level by arbitrage.

14-42

Spot-Futures Parity
The Spot-Futures Parity relationship must hold to
prevent arbitrage opportunities.

(14.2)
(14.3)

FT S (1 r )
FT S 1 r

where:
F = futures price
S = spot price
r = risk-free rate
T = number of periods to contract maturity
14-43

Spot-Futures Parity: Example

Suppose the current price on a non-dividend

paying stock is $25. The risk-free rate is 5.5%.
If a futures contract on this stock is available
with a 6 month maturity, what should its price
be?

(14.3) F

= S(1+r)T
F = $25(1+.055).5
F = $25.6783
14-44

Spot Futures Parity with Dividends

Particularly important for stock index futures

If D represents a dividend paid at or near the end of

the futures contracts life, the spot-futures parity
formula is:
T

FT S 1 r D

If there is dividend yield (d = D/S), the spot-futures

parity formula is:

FT S 1 r d

14-45

Spot-Futures Parity: Example

Suppose the current price on a stock is $25. The

stock has an annual dividend yield of 2.5%.
The risk-free rate is 5.5%.
If a futures contract on this stock is available with
a 6 month maturity, what should its price be?
(14.6)

F = S(1+r-d)T
F = $25(1+.055-.025).5
F = $25.3722

14-46

Stock Index Futures

Futures contracts on stock market indexes:

The S&P 500

The Dow Jones Industrial Average

Cash Settled

Difficult to actually deliver

At expiration, no delivery of shares of stock.

Positions are "marked-to-market" for the last time

and cash settled.
14-47

Stock Index Futures

In September 2008, you believe the broad market is

going to decline over the next three months.
You sell (short) one December 2008 S&P500 index
futures contracts at 1266.7.
Your total short position = $250 X 1266.7 or
$316,675.00

14-48

Stock Index Futures

At maturity, the value of the S&P500

Composite Index is 1250.2.
You shorted the December 2008 S&P500
index futures contracts at 1266.7.
The buyer of your short sale contract owes
you:
(Contract price Current value) X $250
(1266.7 1250.2) X $250 = $4,125

14-49

Single Stock Futures

OneChicago began trading single stock futures in

November 2002.

Single Stock Futures contracts listed on 80 stocks

Joint venture of the CBOE, CME and the CBOT.

Underlying asset = 100 Shares of common stock.

Shares are delivered at expiration.

Industry Basket Futures

14 industry sectors
Each basket = 5 stocks
Cash settled
14-50

Index Arbitrage

Index arbitrage

Trading stock index futures and underlying stocks

to exploit deviations from spot-futures parity.

Often implemented as a program trading

strategy.

Program trading accounts for about 15% of total

trading volume on the NYSE.
About 20% of all program trading involves stockindex arbitrage.
14-51

Index Arbitrage

The S&P500 is currently at 1262.9.

The annual risk-free rate is 4.5%.
The annual dividend yield on the S&P500
is 2.5%.
How can you determine if the futures
contracts are mispriced?

14-52

Index Arbitrage

14-53

Cross Hedging

Hedging a particular spot position with futures

contracts on a related, but not identical,
commodity or financial instrument.
For example:

You decide to protect your stock portfolio from a fall

in value by selling S&P 500 stock index futures
contracts.
This is a cross-hedge if changes in your portfolio
value do not move in tandem with changes in the
value of the S&P 500 index.
14-54

Hedging Stock Portfolios with

Stock Index Futures
Suppose you want to protect the value of a portfolio
against changes in the underlying market.
D = desired Beta = zero

= beta of portfolio to be hedged

VP = dollar value of portfolio to be hedged

VF = dollar value of one S&P 500 futures

contract = 250 S&P 500 index futures
price
VP
Number of contracts ( D p )
VF
Formula:
14-55

Example: Hedging a Stock Portfolio

with Stock Index Futures

You want to protect the value of a

$185,000,000 portfolio over the near term (so,
you will "short-hedge").

p = 1.25
D = 0
S&P futures contract with 3-months to expiration
has a price of 1,480.

How many futures contracts do you need to

sell?
14-56

Example: Hedging a Stock Portfolio

with Stock Index Futures

p = 1.25
D = 0
3-month S&P futures contract = 1,480
VP
Number of contracts (D P )
VF
$185,000,0 00
625 (0 1.25)
250 1,480
S&P 500 Multiplier:
14-57

Hedging Interest Rate Risk

To protect a bond portfolio against changing interest rates,

we may cross-hedge using futures contracts on U.S.
Treasury notes.
It is called a cross-hedge if the value of the bond portfolio
held does not move in tandem with the value of U.S.
Treasury notes.
A short hedge will protect your bond portfolio against the
risk of a general rise in interest rates during the life of the
futures contracts.

Bond prices fall when interest rates rise.

Selling bond futures throws off cash when bond prices fall.

14-58

Hedging Bond Portfolios

with T-note Futures: Formula

Information needed for the formula:

DP = Duration of the bond portfolio

VP =Value of the bond portfolio

DF = Duration of the futures contract

VF =Value of a single futures contract

DP VP
Number of contracts needed
DF VF

14-59

Handy Estimate for the Duration of

an Interest Rate Futures Contract

Rule of Thumb Estimate: The duration of an

interest rate futures contract, DF, is equal to:

The duration of the underlying instrument, DU,

plus
The time remaining until contract maturity, MF.

That is:

D F D U MF

14-60

Example: Hedging a Bond Portfolio

with T-note Futures

You want to protect the value of a

$100,000,000 bond portfolio over the near
term (so, you will "short-hedge").
Suppose the duration of the underlying T-note
is 6.5, and the futures contract has 0.5 years to
expiration.
Also suppose the T-note futures price is 110
(which is 110% of the $100,000 par value.)
14-61

Example: Hedging a Bond Portfolio

with T-note Futures

DP = 8.0

VP = $100,000,000

DF = 6.5+.05 = 7.0

VF = 1.10 * $100,000

How many futures contracts do you need

to sell?
14-62

Example: Hedging a Bond Portfolio

with T-note Futures
DP VP
Number of contracts needed
DF VF
8 $100,000,0 00
1,039
(6.5 0.5) (1.10 $100,000)

14-63

Futures Contract Delivery Options

Cheapest-to-deliver

Sellers option to deliver the cheapest instrument

when a futures contract allows several instruments
for delivery.
Complicates hedging
Increases futures liquidity
U.S. Treasury note futures allow delivery of any
Treasury note with a maturity between 6 1/2 and
10 years.
14-64

Useful Websites

Futures Exchanges:
www.cmegroup.com
www.nymex.com
www.kcbt.com
www.euronext.com (Search for LIFFE)
www.sfe.com.au (Sydney Futures Exchange)
www.tfx.co.jp/en (Tokyo International Financial Futures
Exchange)
www.ses.com.sg (Singapore Exchange)
www.numa.com (Extensive list of worlds futures exchanges)
For Futures Prices and Price Charts:
www.futures.tradingcharts.com
www.barchart.com

14-65