1. Introduction to Futures and Futures Market Yu Chen-Wen President of the Futures Club, National Taiwan University Department of International Business All Rights Reserved by the author The Information on this file may not be reproduced, republished or mirrored without permissions

2. Main Concept - Derivatives • A financial instrument whose value depends on (or derives from) the value of other, more basic underlying asset. • e.g : Futures, Options, Mortgage-back securities.

3. What is Futures?? • Futures contract is alike forward contract, but normally trade on an exchange. example: • Forward contract is an agreement to buy or sell an asset at a certain futures time for a certain price. • example:

4. Terminology in Futures Market & How Could We Trade Futures in Taiwan • Lot • Position • Liquidation, Offset • Delivery • Open Interest • Margin • Margin Call • Settlement Price

5. An Instance of Futures Market • Three investors, A, B and C. • On Oct.10,2004, A long a TAIEX futures for NT1,000,000(5000 index point * NT200 per index point) which delivery month is Jan. 2005 and investor B is the opposite side of this contract. • On Nov. 20, the Taiwan Stock Exchange Capitalization Weighted Stock Index is 4500 point. • On Dec.5, B want to offset the position.The TAIEX futures which has the same delivery month is NT 900,000 on that day. • On Dec.15, investor C short a TAIEX futures for NT920,000 which delivery month is Jan. 2005. • On the third Wednesday of the Jan,2005. Cash settlement occur.TAIEX is 5200 point.

6. Forward Contract Trade on over-the counter market Not standardized Usually one specified delivery date Settle at the end of contract Delivery or final cash settlement usually take place Futures Contract Trade on an exchange Standardized contract Range of delivery dates Settled daily Contract is usually close out prior to maturity Comparison of forward and futures contracts

7. Question: why people need futures?? • Hedgers • Speculators • Arbitrageurs Type of Trader

8. Futures Market • CBOT(Chicago Board of Trade) • London International Financial Futures and Options Exchange • SIMEX(The Singapore Exchange) • TAIFEX(Taiwan Futures Exchange)

9. The Growth in Futures Market (TAIEX) Source:TAIEX Website http://www.taifex.com.tw

10. In TAIEX TAIEX Futures Electronic Sector Index Futures Finance Sector Index Futures MiNi-TAIEX Futures Taiwan 50 Futures 10-year Government Bond Futures 30-Day Commercial Paper Interest Rate Futures Futures Category

11. Others MSCI Taiwan Index Futures CBOT mini-sized Silver Futures Corn Futures 10 Year U.S. Treasury Notes Futures CBOT Dow Jones U.S. Total Market Index Futures (TMI) Futures Category (con’t)

12. Futures price are above spot price Futures price are below spot price Relationship Between Futures Price and Spot Price

13. Determination of Forward and Futures Price *Selective Topic T:Time until delivery date in a forward or futures contract (in years) S0:Price of the asset underlying the forward or futures contract today F0:forward or futures contract price today r:Risk-free rate per annum, expressed with continuous compounding K:delivery price in the contract

14. Determination of Forward and Futures Price In Reality The only determinant is “Demand & Supply”!!!! We could to draw support from Technical Analysis

15. Hedge Strategies Using Futures *Selective Topic • Minimum Variance Hedge Ratio h* = ρ (σS / σF) σS:Standard deviation of the change in spot price σF: :Standard deviation of the change in futures price ρ:Coefficient of correlation between the change in spot and futures price h*:Hedge ratio that minimize the variance of the position

16. Hedge Strategies Using Futures(con’t) *Selective Topic • Optimal Number of Contract N* = [(h*NA)/ QF] NA:Size of position being hedge(unit) QF:Size of futures contract N*:Optimal number of futures contracts for hedging h*:Hedge ratio that minimize the variance of the position

17. “Speculation in futures market is pure gambling. It’s not in the public interest to allow speculator to trade on futures exchange.” Do you agree this statement?? Consider a three-month TAIEX futures, suppose that the underlying index provides a dividend yield 1% per annum.The current index point is 5800 and the risk-free interest rate is 5%.How much this futures worth?? Case Discussion

18. Reference • TAIEX,http://www.taifex.com.tw/ • CBOT,http://www.cbot.com/ • TSEC,http://www.tse.com.tw/ • “Futures, Options, and Other Derivatives 5 edition” John Hull, Prentice Hall • “Technical Analysis of Financial Market” John J.Murphy,New York Institute of Finance