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Futures Markets. I. The Development of Futures Markets 1. Chicago Board of Trade (1848) – grain 2. Chicago Mercantile Exchange (1898) – merge of Chicago Produce Exchange & Chicago Butter & Egg Board 3. Financial Futures A. Foreign Currency Futures (1972) B. GNMA Futures (1975)
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Futures Markets • I. The Development of Futures Markets • 1. Chicago Board of Trade (1848) – grain • 2. Chicago Mercantile Exchange (1898) – merge of Chicago Produce Exchange & Chicago Butter & Egg Board • 3. Financial Futures • A. Foreign Currency Futures (1972) • B. GNMA Futures (1975) • C. T-Bill Futures (1976) • D. T-Bond Futures (1977) • E. Eurodollar Futures (1981) • S&P500 Index Futures (1982) • Dow-Jones Index Futures (1997)
II. Futures Contracts • 1. Forward Contract vs. Futures Contract • 2. Basics of Futures Contract • Types of Futures • Grains & Oilseeds • Livestock & Meat • Food and Fiber • Metals & Energy • Financials & others • Quotations • (Bonds) • (Contract Specifications) • III. Mechanics of Trading • 1. Trading Pits vs. GLOBEX • 2. The Clearing House
3. Marking to Market • Initial Margin & Maintenance Margin (Performance Bond) • Daily Settlement • Example • Cash Deliver vs. Actual Delivery • Actual delivery: less than 1% • Cash delivery: stock index futures • Regulations • CFTC: Commodity Futures Trading Commissions • Price Limit (e.g., silver @ $1/per day) • IV. Futures Market Strategies • 1. Hedging • Short Hedge • Long cash, short futures
Long Hedge • short cash, long futures • Examples • - If you own an asset • - If you plan to sell an asset • - If you are short an asset • - If you are committed to buying an asset in the future • - If you have issued a floating rate liability • - If you plan to issue a liability
Bond Portfolio _____ Hedge • A long-term bond portfolio manager forecasts that interest rate will increase over the next few months. The manager holds a portfolio of $1 million face value, 11-7/8s, 2023 corporate bond.
Stock Portfolio Short Hedge – On 3/1, a portfolio manager was concerned about the market over the next six months. • On 3/1, the SP500 index futures was @1,190, the manager shorted 5 contracts {[1,285,700/ (1,190 x 250)]=4.3} • On 9/2, SP500 index futures is @ 1,218, the manager longs 5 contracts . • Loss in the futures: (1,218-1,190) x250 x 5 = 35,000
2. Hedge Ratio • Naïve hedge ratio • Minimum variance hedge ratio • Run a linear regression line S = + F, where is the minimum variance hedge ratio • # of futures contract: N = (S/F) • 3. Which futures commodity? • Cross Hedge – choose the one that has high correlation between futures price and underlying asset price • 4. Which Expiration? • Choose a future with expiration month close to but after the hedge terminates • Deferred contract may have liquidity problem
V. Futures Pricing • Spot-Futures Parity (Cost of Carry Model) • 1. F0 = S0 (1+r)T • Example: F0 = 360(1.05)1 = 378 • 2. Arbitrage occurs when the equilibrium relation is violated (e.g., F0 = 380) • Example T0T1 . T0: borrow $360 $360 buy gold -$360 short futures@380 0 T1: deliver gold $380 repay loan (P&I) -$378 ---------------------------------------------------------------------- Cash flows 0 +2
V. Other Futures & Forwards • 1. Options on Futures • 2. Hedging with Foreign Currency Forwards • Scenario: On June 1, a multinational firm with a British subsidiary decides it will need to transfer ￡10 million from an account in London to an account with a NY bank. Transfer will be made on September 6. The firm is concerned that pound will weaken. • Analysis: The ￡ end up worth $13,570,000 – 12,375,000 = $1,195,000 less but are delivered on the forward contract for $13,570,000, thus eliminating the risk.
