FINANCE IN A FINANCE IN A CANADIAN SETTINGCANADIAN SETTING

Sixth Canadian EditionSixth Canadian Edition

Lusztig, Cleary, Lusztig, Cleary, SchwabSchwab

CHAPTER TWENTYCHAPTER TWENTY

FuturesFutures

Learning ObjectivesLearning Objectives

1. Explain how futures contracts differ from options.1. Explain how futures contracts differ from options.

2. Discuss the difference between futures contracts 2. Discuss the difference between futures contracts and forward contracts.and forward contracts.

3. Define the terms backwardation and forwardation.3. Define the terms backwardation and forwardation.

4. Explain arbitrage and demonstrate how it works in 4. Explain arbitrage and demonstrate how it works in commodity and financial futures.commodity and financial futures.

5. Describe how different types of futures (foreign 5. Describe how different types of futures (foreign currency, interest rate, stock index, etc.) contribute currency, interest rate, stock index, etc.) contribute to risk management.to risk management.

IntroductionIntroduction

Physical commodities and financial Physical commodities and financial instruments are traded in cash marketsinstruments are traded in cash markets

Two types of cash markets:Two types of cash markets: spot markets – feature immediate deliveryspot markets – feature immediate delivery forward markets – have deferred deliveryforward markets – have deferred delivery

A way to mitigate risk is through:A way to mitigate risk is through: Forward contractsForward contracts – a negotiated – a negotiated

agreement between a buyer and a seller to agreement between a buyer and a seller to lock in a price at which a future transaction lock in a price at which a future transaction will occur will occur

IntroductionIntroduction Who uses forward contracts?Who uses forward contracts?

oil production and refinery companiesoil production and refinery companies mining companiesmining companies

An alternative way of locking in future prices is An alternative way of locking in future prices is through:through: Futures contractsFutures contracts – agreements to trade a – agreements to trade a

specified asset at a specified price and time in specified asset at a specified price and time in the futurethe future

Characteristics of futures contracts include:Characteristics of futures contracts include: contracts are standardizedcontracts are standardized they trade on futures marketsthey trade on futures markets they are contracts with a futures market clearing they are contracts with a futures market clearing

househouse

Basic ConceptsBasic Concepts

Conceptually, forward or futures contracts Conceptually, forward or futures contracts can be written on anything, including oil, can be written on anything, including oil, grains, metals, weather, currencies, and grains, metals, weather, currencies, and interest ratesinterest rates

Futures contracts can be divided into two Futures contracts can be divided into two broad categories:broad categories:

1. commodities – agricultural, metal, and 1. commodities – agricultural, metal, and energy-related productsenergy-related products

2. financials – foreign currencies, debt and 2. financials – foreign currencies, debt and equity instrumentsequity instruments

Basic ConceptsBasic Concepts

Commodity futures contractCommodity futures contract –– when the when the underlying asset is a real commodityunderlying asset is a real commodity

Financial futures contractsFinancial futures contracts –– when the when the underlying asset is a financial obligation such underlying asset is a financial obligation such as currency, bond, or stock portfoliosas currency, bond, or stock portfolios

Futures priceFutures price –– is the price set out in a futures is the price set out in a futures contractcontract

Settle priceSettle price –– the price at which the market’s the price at which the market’s books were balanced at the end of the day’s books were balanced at the end of the day’s tradingtrading

Basic ConceptsBasic Concepts

Organized exchanges are crucial to the Organized exchanges are crucial to the usefulness of futures contracts as risk-usefulness of futures contracts as risk-management toolsmanagement tools Futures trade on:Futures trade on:

WCE, ME (Canada)WCE, ME (Canada) CME, NYCE, NYME, NYFE (US)CME, NYCE, NYME, NYFE (US)

Futures contracts have maturities of less Futures contracts have maturities of less than seven yearsthan seven years

Futures contracts are standardizedFutures contracts are standardized

Options and FuturesOptions and Futures

Options give the owner the right to buy Options give the owner the right to buy or sell the underlying assetor sell the underlying asset

Futures and forward contracts carry the Futures and forward contracts carry the obligation to trade the underlying assetobligation to trade the underlying asset

Both options and futures are zero sum Both options and futures are zero sum investmentinvestment

Organization of Organization of Futures MarketsFutures Markets

Investors must establish a commodity Investors must establish a commodity or margin account in order to trade or margin account in order to trade futures contracts futures contracts

Margin requirements are between 5 and Margin requirements are between 5 and 10 percent of the value of the position10 percent of the value of the position

Futures markets are subject to daily Futures markets are subject to daily limits on price fluctuationslimits on price fluctuations

Investors in futures may also be subject Investors in futures may also be subject to position limitsto position limits

Marketing to MarketMarketing to Market

Marking to marketMarking to market –– the futures markets the futures markets elaborate system of daily adjustments elaborate system of daily adjustments of contract prices and margin accountsof contract prices and margin accounts

Neither party deals directly with each Neither party deals directly with each otherother

On futures exchanges, almost 90 On futures exchanges, almost 90 percent of all positions are closed out percent of all positions are closed out before they maturebefore they mature

Hedges and Hedges and SpeculatorsSpeculators

HedgersHedgers –– traders who open futures positions to traders who open futures positions to manage risk that arises from other businessesmanage risk that arises from other businesses hedgers:hedgers:

are in the market to buy insuranceare in the market to buy insurance

SpeculatorsSpeculators –– investors who open futures positions investors who open futures positions expecting to close them again at more advantageous expecting to close them again at more advantageous pricesprices speculators:speculators:

provide liquidity to the market and increase efficiencyprovide liquidity to the market and increase efficiency are in the market to make moneyare in the market to make money

Commodity Futures Commodity Futures PricesPrices The Expectations HypothesisThe Expectations Hypothesis

states that future prices of a commodity should be what states that future prices of a commodity should be what traders expect the spot price to be in the futuretraders expect the spot price to be in the future

The Net Hedging HypothesisThe Net Hedging Hypothesis Normal backwardationNormal backwardation –– when a futures market has a when a futures market has a

shortage of hedgers in long positions which means the shortage of hedgers in long positions which means the futures contract price will fall below the spot price futures contract price will fall below the spot price expected in the future (F expected in the future (F E(S)) E(S))

Normal forwardationNormal forwardation –– a futures market with a shortage a futures market with a shortage of hedgers on the short side of the contract which causes of hedgers on the short side of the contract which causes the future price to exceed the expected spot price (F > the future price to exceed the expected spot price (F > E(S))E(S))

Commodity Futures Commodity Futures PricesPrices

Commodity Futures ArbitrageCommodity Futures Arbitrage when futures contracts approach when futures contracts approach

maturity the futures price equals the spot maturity the futures price equals the spot price, otherwise an arbitrage situation price, otherwise an arbitrage situation occursoccurs

For assets that are not maturing, For assets that are not maturing, arbitrageurs set limits on the difference arbitrageurs set limits on the difference between the futures prices and the between the futures prices and the current spot prices known as current spot prices known as “boundaries” “boundaries”

Commodity Futures Commodity Futures PricesPrices

The boundaries formula is: F The boundaries formula is: F S(1 + r) S(1 + r)tt + ct+ ct

where:where: F = future priceF = future price

S = spot priceS = spot price

r = annual risk-free interest rater = annual risk-free interest rate

t = time until maturity of the futures contract t = time until maturity of the futures contract measured in yearsmeasured in years

c = annual storage, insurance, transportation for c = annual storage, insurance, transportation for carrying an inventory of underlying assetscarrying an inventory of underlying assets

When the futures prices exceeds the upper limit When the futures prices exceeds the upper limit there is a arbitrage situationthere is a arbitrage situation

Financial Futures PricesFinancial Futures Prices

Foreign currency futures:Foreign currency futures: allow one to lock in an exchange rate at a allow one to lock in an exchange rate at a

specified point in the futurespecified point in the future are available in all major currenciesare available in all major currencies are valuable risk-management tools for are valuable risk-management tools for

firms that engage in international businessfirms that engage in international business Foreign currency exposureForeign currency exposure – the term used – the term used

when a business has a net contractual when a business has a net contractual obligation in a foreign currencyobligation in a foreign currency

Financial Futures PricesFinancial Futures Prices

Interest rate forward and futures contracts allows Interest rate forward and futures contracts allows one to lock in a price at which a debt instrument one to lock in a price at which a debt instrument is to be bought or sold in the futureis to be bought or sold in the future

Interest rate futures should be considered when:Interest rate futures should be considered when:1. Borrowers want to protect against future interest rate 1. Borrowers want to protect against future interest rate

increasesincreases

2. Investors want to protect against future interest rate 2. Investors want to protect against future interest rate decreasesdecreases

3. Financial institutions are exposed to interest rate risk3. Financial institutions are exposed to interest rate risk

4. Speculators want to bet on interest rates moving in a 4. Speculators want to bet on interest rates moving in a particular directionparticular direction

Financial Futures PricesFinancial Futures Prices

Stock index futures:Stock index futures: allows one to lock in a future price at allows one to lock in a future price at

which one can buy the portfolio of which one can buy the portfolio of stocks that make up a stock market stocks that make up a stock market indexindex

are for specified amounts of are for specified amounts of underlying assetsunderlying assets

are settled in cashare settled in cash

Financial Futures PricesFinancial Futures Prices

Program tradingProgram trading – when – when institutions use direct computer institutions use direct computer links to stock exchanges to links to stock exchanges to assemble large portfolios of stocks assemble large portfolios of stocks that are based on theoretical that are based on theoretical equivalence of positions equivalence of positions

in index futures and theirin index futures and their underlying stocks underlying stocks

SummarySummary

1. Futures contracts and forward contracts 1. Futures contracts and forward contracts are devices for locking in prices for future are devices for locking in prices for future transactions. They commit the investor to transactions. They commit the investor to buying or selling in the future at that buying or selling in the future at that price. There is no choice on whether or price. There is no choice on whether or not to exercise. Futures and forward not to exercise. Futures and forward contracts are less flexible than options. contracts are less flexible than options. Their compensating benefit is that Their compensating benefit is that futures entail no up-front cost.futures entail no up-front cost.

SummarySummary

2. Futures contracts are standardized 2. Futures contracts are standardized agreements with futures market clearing agreements with futures market clearing houses to buy or sell assets at specified houses to buy or sell assets at specified times and prices. Commodity futures times and prices. Commodity futures contracts are for important agriculture contracts are for important agriculture products, metals, oil, and other commodities. products, metals, oil, and other commodities. Financial futures contracts that allow one to Financial futures contracts that allow one to buy or sell foreign currencies, debt buy or sell foreign currencies, debt instruments, and stock portfolios have instruments, and stock portfolios have become important risk-management devices.become important risk-management devices.

SummarySummary

3. If a commodity futures price is lower 3. If a commodity futures price is lower than the spot price traders expect to than the spot price traders expect to see at the time the futures contract see at the time the futures contract matures, the market for that futures matures, the market for that futures contract is said to display contract is said to display backwardation. If the futures price is backwardation. If the futures price is higher than the expected spot price, the higher than the expected spot price, the market is said to display forwardation.market is said to display forwardation.

SummarySummary

4. Commodity futures are set by the 4. Commodity futures are set by the interaction of the supply and demand interaction of the supply and demand for price hedging, but are limited by an for price hedging, but are limited by an arbitrage constraint. Futures contracts arbitrage constraint. Futures contracts are important tools for risk are important tools for risk management. Commodity futures management. Commodity futures contracts can be used to lock in prices contracts can be used to lock in prices for the firm’s inputs and products and for the firm’s inputs and products and hedge against price changes.hedge against price changes.

SummarySummary

5. Foreign currency futures can be used to 5. Foreign currency futures can be used to lock in exchange rates and limit foreign lock in exchange rates and limit foreign currency risk. Interest rate futures lock in currency risk. Interest rate futures lock in the prices and yields of debt instruments, the prices and yields of debt instruments, allowing firms to hedge against the risk allowing firms to hedge against the risk of interest rate fluctuations. Stock index of interest rate fluctuations. Stock index futures contracts lock in the prices of futures contracts lock in the prices of stock portfolios based on widely used stock portfolios based on widely used stock indices.stock indices.