Chapter 26 FINANCIAL FUTURES MARKETS Futures Contracts

Chapter 26 FINANCIAL FUTURES MARKETS

Futures Contracts z basic role: hedge against price risk z exchange traded/created products: regulated z originally: commodities (grains, coffee, gold etc. ) z now: financial futures y stock index futures y interest rate futures y currency futures z value of a futures contract is derived from the value of the underlying instrument z recent growth: volatility growth; can handle

Futures Contracts I z Contract between a buyer and a seller: ybuyer agrees to receive an asset at a specified price on a designated date. yseller agrees to delivery the asset at that price on that date. z elements yfutures price ysettlement/delivery date yunderlying asset (commodity)

Futures Contracts II zpositions ylong futures (buy, profit if price increases) yshort futures (sell, profit if price decreases) ze. g. 27 Jan CME frozen pork bellies y. FEB 05 94. 075, MAR 05 95. 050, APR 05 96. 700 yif X buys and Y sells a MAR 05 contract, and the spot price at the end of March is higher/lower…

Liquidating a Futures Position z settlement dates yoften: Mar, Jun, Sept, Dec ynearby futures contracts: closest to settlement date ymost distant futures contracts: opposite (e. g. 1 yr) z liquidating a futures position ybefore settlement date: take an offsetting position yon settlement date: take delivery of the underlying asset (v. cash settlement contracts) – c. 2% z open interest: liquidity measure - outstanding unliquidated contracts

Role of Clearinghouse z every futures exchange has a clearinghouse yguarantees that buyer/seller satisfy their obligations (buyer/seller of last resort) xif party defaults, steps in to take position xtherefore risk centralised: exchange’s, not parties’ ysimplifies the unwinding of futures positions prior to the settlement date xmatching of buyers/sellers on liquidation xinitial parties may not transact with each other: follow clearinghouse’s instructions

Margin Requirements I z initial margin yminimum dollar amount per futures contract ycan be interest-bearing securities z equity: margin posted + cumulative gains/losses: floats z settlement price: ‘representative’ closing price to calculate equity account value zfutures contracts marked-to-market daily: ybuyer (seller) realizes a profit if the price increases (decreases) ybuyer (seller) realizes a loss if the price decreases (increases)

Margin Requirements II z maintenance margin y minimum level to which an equity position may fall due to adverse price movements before z variation margin y new deposits required to bring equity account back to the initial margin level (must be cash) y [can also withdraw if prices move in favour] z buying on margin (securities) v futures: y former: borrow to buy securities, using them as collateral y latter: typically no borrowing; both parties deposit margins z leverage: if 5% margin, can buy 20 x contracts

Market Structure z Exchange Trading ypit with open outcry auction system yseat needed to trade (can lease one) yno market makers z floor traders y. Locals: trade for own account, provide liquidity, usually close positions by nightfall yfloor or pit brokers: own account + (mostly) execute orders z electronic trading systems: CME has pit + GLOBEX 2

How forward contracts differ z non-standard; terms individually negotiated z no clearinghouse. Therefore: y default risk y thin markets y OTC z intended to settle by delivery z marking to market depends on parties’ wishes: may be harder to price z otherwise, identical to futures

The Role of Futures in Financial Markets z use cash/spot or futures market to alter price risk exposure? yfactors: liquidity, transactions costs, taxes, leverage z price discovery in futures markets transmitted to cash markets z arbitrageurs keep cash market prices in line z do futures markets lead to excess volatility or just facilitate incorporation of more information? z (new risk management techniques, regulation needed for new instruments)

CME contracts I z commodity y feeder cattle & live cattle; lean hogs & pork bellies; milk & butter; random length lumber… z environmental y Asia/Pacific, Europe, US weather z equity y stock market indices: S&P, NASDAQ, Nikkei, Goldman Sachs Commodity Index y cash settlement z foreign exchange y inc. cross rates (non$US), 3 new Cent Eur currencies y e. FX 24 hr/day trading

CME contracts II z interest rates y. T-bill: a T-bill w 13 wks to maturity and face value $1 mn y. Eurodollar CD x$US on deposit in banks outside the US xterms as T-bill; pay LIBOR y. T-bond (CBT): hypothetical $100 k, 20 yr 6% coupon x. CBT conversion factors allow settlement in existing bonds y. Euroyen x 3 -month TIBOR or LIBOR; principal 100 k ¥ xfully fungible with Euroyen LIBOR, TIBOR on SGX

Euronext. liffe contracts I zuniversal stock futures, index futures z. Short Term Interest Rate (STIR) y. EONIA (Euro Overnight Index Average): ECB unsecured inter-bank loans y 3 -mo Euro (EURIBOR, LIBOR), Sterling, Swiss Franc (Euroswiss) y 3 -mo Euroyen (LIBOR, TIBOR)

Euronext. liffe contracts II z. Government Bond Contracts y. Long Gilt (8. 75 – 13 yrs) y. Schatz (2 yr), Bund (10 yr): German government bonds y. Japanese Government Bond (JGB) zcommodities ycocoa, robusta coffee… no livestock z. Euronext and Météo France = Next. Weather, but not yet