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Economic Purposes of the Futures Market
- Price discovery
- Risk transference
- Lower transaction costs
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Economic Purposes of the Futures Market - "1. Price discovery"
- Provides information to public about future spot prices.
- Increases competitiveness of markets
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Economic Purposes of the Futures Market - "2. Risk transference"
- Enables investors & borrowers to protect assets & liabilities against risks e.g. changes in interest rates, exchange rates & security prices
- Can be likened to buying insurance policies
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Economic Purposes of the Futures Market - "3. Lower transaction costs"
But markets are zero sum games. i.e. one person’s loss is another’s gain.
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Futures Contract
Legally binding agreement to buy or sell a specified quantity of a specified commodity/financial instrument for a specified delivery date in the future at a price agreed upon at setting up of contract
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Features of futures contract(s)
- exchange traded contracts
- highly standardised contract in terms of amounts, prices & conditions unlike a forward contract
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Derivative and derivative markets - "Types of derivatives markets"
- Futures markets (organised exchange market)
- Forward markets (OTC markets)
- Options contracts (many organised markets)
- Swap markets (OTC markets)
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Risk Transference
- First, risks must be identified, measured & managed.
- Risk management strategies may be internal or external
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Risk Transference - "Hedging"
- Transferring the risk of unanticipated changes in prices, interest rates or exchange rates to another party
- Change in market price of a commodity or security in physical market is offset by a profit or loss on futures contract in futures marke
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Risk Transference - Example - "A dairy farmer who has a very large scale operation will be selling whole milk powder in a couple of months. He is concerned that milk price is going to fall in meantime. How can he hedge this price risk?"
- Use exchange traded futures contract & conduct a transaction in futures market that corresponds with what is planned to be done in physical market at later date
- Farmer enters into a whole milk powder futures contract to sell milk powder at a specified price & amount
- So, if prices fall, futures contract will rise in value to offset loss in the physical market from fall in milk prices
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Australasian Futures & Options Exchanges
- ASX recently bought Sydney Futures Exchange (SFE)
- NZ Futures market- established 1985 by NZ FIs but bought by Sydney Futures Exchange Ltd in 1992
- Electronic screen trading (relatively small size & spread of participants). Note majority of futures markets are electronic
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Two main types of futures contracts
- Commodity (e.g. gold, wheat, pork bellies)
- Financial (e.g. shares, government securities, money market instruments, share indices)
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1 long futures contract
- Agreement to buy futures
- Hedger: Will have money to invest in future
- Speculator: believes market will go up
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1 short futures contract
- Agreement to sell futures
- Hedger: Has shares to sell in future
- Speculator: Believes market will fall.
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Operations of futures market- Initial Margin & it's purpose
- Funds put up as security for guarantee of contract fulfilment at time futures position is established
- Purpose: to cover the maximum one-day movement in the futures contract
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Initial margin features
- Paid by both buyer & seller to clearing house
- Set by Futures Exchange for its Members who then set margin for client (depends on volatility & standing
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Operations of futures market - Variation Margin
- Any adverse price movement in the market must be covered daily by further deposit of funds (maintenance margin call).
- Known also as settlement to market when contract is marked-to-market daily by clearing house.
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Variation Margin - Example - "1 NZX15 futures contract bought at 6,000 × $10= $60,000, so you put up $1,000 at the start as initial margin. So if on next day, index price drops to 5990..."
- 5990 × 10 = $59,900,
- $100 variation
- You will have a margin call to put $100 in to margin account so to top-up initial deposit.
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Futures market operation: Clearing house
When a futures deal is concluded on the Exchange, a record is goes to the clearing house who then assumes responsibility for admin. & fulfilment of contract
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Role of Clearing House
- The clearing house guarantees the performance of clearing house member by becoming opposite party in all transactions, being buyer to every selling clearing member & seller for every buying clearing member.
- Often owned by Exchange but operates as separate entity
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Clearing House - Example
 - Sells one contract to B at 97 & buys one contract from S at 97
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Clearing House - Example
- As there is one new ‘long’ & one new ‘short’ position, the open position on exchange increased by one contract
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Clearing House - Note - "An agreement to buy (long position) always..."
Balanced by short position (agreement to sell)
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Operation of futures market - Closing out of a futures contract
- Actual delivery of contract
- Majority of financial futures closed out before expiry date
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Closing out of a futures contract - "1. Actual delivery of contract"
- Seldom used with financial contracts (as managing a risk exposure or trying to profit)
- Final settlement of futures contracts may be standard delivery or cash settlement
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Closing out of a futures contract - "2. Majority of financial futures closed out before expiry date"
Reverse trade by taking a position in market equal & opposite to that already held
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Participants in the markets
- Hedger
- Arbitrageur
- Speculator
- Traders
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Participants in the markets - Hedger
- Attempt to reduce price risk (from interest rate, exchange rate & share price)
- “Conducts same transaction in futures market today that is to be carried out in physical market in future time”
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Participants in the markets - Arbitrageur
- Someone taking advantage of price differentials between two markets & making riskless profits.
- e.g. differentials between futures contract price & physical spot price of the underlying commodity
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Participants in the markets - Speculator
- someone prepared to take-over hedgers risk or holding a contrary view to another speculator.
- Enter market in expectation that market price will move in a favourable direction for them
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Speculator - Example - Speculators who expect price of underlying asset go up, go down
- Asset up = go long
- Asset down = go short
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Participants in the markets - Traders
- Special class of speculator
- Trade on very S/T changes in the price of futures contracts (i.e. intra-day changes)
- Provide liquidity to the market
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Hedging - Example (Part 1) - Individual has $60,000 worth of shares representing NZX15 index. Assume physical share market is at 6,000 & future market’s price is also at 6,000. Assume basis risk is zero (basis = difference between future & spot price), means futures & physical prices differences are the same, & will stay the same May need $60,000 in 3 months, so want to hedge position. Doesn’t want to sell the shares now.
- 1 futures contract is $60,000 as 6,000 × 10 = 60,000.
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Hedging - Example (Part 2) - "Shares now worth $56,000"
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Hedging - Example (Part 3) - "The share index = 6400 in three months"
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Risks of Using Futures for Hedging
- Standard Contract Size
- Margin Risk
- Basis Risk
- Cross-commodity Hedging
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Risks of Using Futures for Hedging - Standard Contract Size
A perfect hedge may not be possible (i.e. due to contract size, the physical market exposure may not exactly match the futures market exposure)
- 90-day bank bill —$1,000,000 Face Value
- 3 year Govt. bond —$100,000 Face Value
- Listed Company Share —1,000 shares
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Risks of Using Futures for Hedging - Margin Risk
- Initial margin- buyers & sellers need to pay initial margin (2-10% of futures contract)
- Further cash required if prices move adversely (i.e. margin calls)
- Opportunity costs & cash-flow risks associated with margin requirements
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Risks of Using Futures for Hedging - Basis Risk
A perfect hedge requires there to be zero initial & final basis risk between the physical and futures markets
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Derivatives - Forward Contract
- Agreements to buy or sell an asset at a certain time in the future for a certain price but NOT traded on a futures exchange
- Private agreements
- One party assumes long position & agrees to buy the asset for specified price & date while other assumes short position & agrees to sell the asset on same date for same price
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Differences between futures & forwards - Forwards
- Don’t have to conform to standards of an exchange
- Prices are less transparent than exchange
- Usually a single delivery date unlike futures, range of delivery dates
- Not marked to market daily like future contracts
- Market players- may be known to each other
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Forward Rate Agreements (FRAs)
- OTC agreement between two parties on an interest rate level that will apply at a specified future date
- Allows lender & borrower to lock in interest rates based on a notional principle (no exchange of principal)
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FRA specifics
- Specifies FRA settlement date when compensation is paid
- Specifies FRA contract date on which cover is based: If a party wants to protect against rise in 3-month interest rates in 6 months time when they intend to borrow, they may use a FRA 6Mv9M
- Dealer quotes FRA as 6Mv9M 8.50-8.00 so in 6 months dealer will lend 3-month money at rate=8.50% or borrow at 8.00%
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