Chapter 19 FUTURES

Where the Hedgers and the Speculators Meet

OUTLINE Features of a Futures Contract Mechanics of Trading Futures Contracts : The Global Scene Financial Futures Equity Futures in India Pricing of Futures Contracts

Use of Futures Contracts

Assessment

WHAT IS A FUTURES CONTRACT? A forward contract is an agreement between two parties to

exchange an asset for cash at a predetermined future date

for a price that is specified today. A futures contract is a standardised forward contract.

DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS

FORWARDS
TRADED OVER THE COUNTER

FUTURES
TRADED ON EXCHANGE

NO SECONDARY MARKET
TERMS NEGOTIATED BETWEEN BUYER AND SELLER MOST CONTRACTS END WITH PHYSICAL DELIVERY CREDIT RISK ASSUMED BY BUYER

SECONDARY MARKET EXISTS

STANDARDIZED CONTRACT (QTY, DATE & DELIVERY CONDITIONS) NORMALLY NO DELIVERY OFFSETTING TRANSACTION CREDIT RISK ASSUMED BY CLEARING CORPORATION AND MEMBER FIRMS

NO COLLATERAL SECURITY
PARTICIPATION LIMITED TO SMALL NO. OF LARGE TRADERS

COLLATERAL POSTED MARKET TO THE MARKET

LARGE NUMBER OF PARTICIPANTS

FUTURES TERMINOLOGY
SPOT PRICE
FUTURES PRICE CONTRACT CYCLE

EXPIRY DATE
CONTRACT SIZE
THE AMOUNT OF ASSET THAT HAS TO BE DELIVERED UNDER ONE CONTRACT. FOR INSTANCE, THE CONTRACT SIZE ON NSES FUTURES IS 200 NIFTIES

BASIS
FUTURES PRICE - SPOT PRICE

INITIAL MARGIN
MARKING TO MARKET MAINTENANCE MARGIN

PAYOFFS TO THE FORWARD BUYER AND FORWARD SELLER

A : Forward Buyer Profit B : Forward Seller Profit

C
C P

Loss
C = Contract price P = Actual price

Loss

MECHANICS OF TRADING Trading in futures is more complex than trading in stocks. Inter alia it involves Intermediation by a clearing house Margins Marking - to - market

THE ROLE OF THE CLEARING HOUSE

Money

Money

Long position

Clearing house

Short position

Asset

Asset

MARGINS When you execute a futures trade, you have to provide the initial margin. If you incur sustained losses from daily marking-tomarket, and your margin amount falls below a critical level called the maintenance margin you have to replenish the margin amount.

MARKING-TO-MARKET
While forward contracts are settled on the maturity date, futures contracts are marked to market on a periodic basis.
Assume that the spot price of gold is $450 and the four period futures contract in gold has a price of $460. In the wake of changes in the price of the gold futures contract, the cash flow to the buyer and seller of this contract will be as shown in the last two columns of the following table.

Time Period

Gold Forward Futures Futures contract Buyers cash flow Sellers cash flow Buyers cashflow Sellers cash flow 465 455 460 465 $0 0 0 5 0 0 0 -5 $5 -10 5 5 $-5 10 -5 -5

1
2 3 4

FUTURES CONTRACTS GLOBAL SCENE

Commodity Futures Cocoa Cotton Aluminum Gold Crude oil Soyabean oil CSCE FOX CTN COMEX LME IPE NYMEX CBT IMM LIFFE MCE Phil SE Exchange CSCE, FOX CTN COMEX,LME LME IPE, NYMEX CBT Financial Futures U.S Treasury bills Eurodollar deposits Standard & Poor's (S&P) Index Sterling Exchange IMM, MCE IMM, LIFFE IMM IMM, LIFFE,MCE Phil SE

Coffee , Sugar and Cocoa Exchange , New York London Futures and Options Exchange New York Cotton Exchange Commodity Exchange , New York London Metal Exchange International Petroleum Exchange of London New York Mercantile Exchange Chicago Board of Trade International Monetary Market(at the Chicago Mercantile Exchange) London International Financial Futures Exchange Mid America Commodity Exchange Philadelphia stock Exchange

MAJOR TYPES OF FUTURES CONTRACTS

Type

Example

Futures contracts on debt instruments

US Treasury bond futures contract: This is a contract for delivery of US Treasury bonds with $100,000 face value and having a maturity of at least 15 year from the delivery date

Futures contract on monetary metals

Futures contract on gold : This is a contract for delivery of 100 troy ounces of gold of 0.995 fineness Futures contract on British pound: This is a contract for delivery of 25,000 British pounds, on the appropriate future date Futures contract on S&P 500: The underlying value of the contract is $500 times the S & P 500 index. Unlike other futures contracts, the settlement of an index futures contract is by cash payment

Futures contract on foreign currencies

Futures contract on stock markets indices

FINANCIAL FUTURES Equity Futures

Interest Rate Futures

Foreign Exchange Futures

STOCK INDEX FUTURES S & P CNX NIFTY FUTURES

TRADING CYCLE

MAXIMUM OF 3 MONTHS

EXPIRY DAY

LAST THURSDAY OF THE EXPIRY MONTH

INDIVIDUAL STOCK FUTURES

TRADING CYCLE EXPIRY SIZE MAXIMUM 3 MONTHS LAST THURSDAY OF THE EXPIRY MONTH SAME AS THE LOT SIZE OF OPTIONS CONTRACT FOR A GIVEN UNDERLYING ON INTRODUCTION, THE PREVIOUS DAYS CLOSING PRICE OF THE UNDERLYING SECURITY CASH-SETTLED. DAILY MARKTO-MARKET

BASE PRICE

SETTLEMENT

PRICING OF EQUITY FUTURES

COST-OF-CARRY RELATIONSHIP
F0 = S0 (1 + rf)T S0 = RS. 400 rf = 1% PER MONTH 3 MONTHS FUTURES CONTRACT F0 = S0 (1 + rf)T = 400 (1.01)3 = 412.12 SUPPOSE 3-MONTHS FUTURES RS. 412
ACTION INITIAL CASH FLOW
+ 400

CASH FLOW AT (3 MONTHS)

- 400 (1.01)3 = - 412.12

BORROW RS.400 NOW & REPAY WITH INT. AT TIME T BUY A SHARE SELL A FUTURES CONTRACT (F0 = RS. 414)

- 400 0 0

ST
414 - ST RS. 1.88

PRICING OF EQUITY FUTURES 2 F0 = S0 erf t WHEN THE UNDERLYING ASSET PRODUCES INCOME TO THE OWNER F0 = S0 (1 + rf - d)T SUPPOSE STOCK INDEX S0 = 1200 rf = 1% P.M

= 0.25% P.M

F0 = 1200 (1 + 0.0075)3 = 1227.2

PRICING OF TREASURY BOND FUTURES A TREASURY BOND FUTURES CONTRACT IS A CONTRACT FOR DELIVERY IN FUTURE OF TREASURY BONDS HAVING CERTAIN FUTURES. TREASURY BOND FEATURES ARE VALUED THE WAY STOCK INDEX FUTURES ARE VALUED, WITH ONE DIFFERENCE.

F0 = (S0 - PVC) (1 + rf )T

PRICING OF COMMODITY FUTURES

(STORABLE COMMODITIES)
FUTURES PRICE = SPOT PRICE + PV OF PV OF STORAGE CONVENIENCE COSTS YIELD

(1 + rf )T

PERI SHABLE COMMODITIES FUTURES PRICES VS. EXPECTED SPOT PRICES

SO FAR .. RELN FUTURES PRICES & CURRENT SPOT PRICE A CONTROVERSY .. THEORY OF FUTURES PRICING CONCERNS .. RELN .. FUTURES PRICE & THE EXPECTED VALUE .. SPOT PRICE IN FUTURE

EXPECTNS HYPOTHESIS
NORMAL BACKWARDN CONTANGO FUTURES PRICES

: : :

F = E (St) F < E (St ) F > E (St ) SUPPLIERS HEDGE BUYERS HEDGE

CONTANGO EXPECTNS HYPOTHES NORMAL BACKWARDN TIME DELIVERY DATA

WHO USES FUTURES CONTRACTS? Hedgers Short (sell) hedge Long (buy) hedge Speculators Arbitrageurs Futures-futures arbitrage

Cash-futures arbitrage

WHAT ECONOMIC FUNCTIONS DO FUTURES AND OPTIONS PERFORM?

ECONOMIC FUNCTIONS RISK TRANSFER PRICE DISCOVERY MARKET COMPLETION LOWER VOLATILITY HIGHER LIQUIDITY LOWER TRANSACTION COSTS

EMPIRICAL EVIDENCE
CONCLUSION DERIVATIVES .. SHIFT .. SUPPLY CURVE OF INVESTMENT CAPITAL DOWN AND TO THE RIGHT DERIVATIVE MARKETS .. TRUE CHILD OF THE FINANCIAL & INFORMATION SERVICES REVOLN LEADING EDGE .. GLOBAL INTEGRATION OF FINANCE
RICHARD O BRIEN

CRITIQUE AND RESPONSE

NOTWITHSTANDING ENDORSEMENT OF DERIVATIVES .. BY FINANCIAL ECONOMISTS AND BUSINESS PERSONS WIDESPREAD CONCERN .. JOHN SHAD

FUTURES AND OPTIONS ARE THE TAIL WAGGING THE DOG. THEY HAVE ESCALATED THE LEVERAGE AND VOLATILITY OF THE MARKETS TO PRECIPITOUS, UNACCEPTABLE LEVELS
MANY IN THE PROFESSION DISAGREE VOLATILITY IN THE UNDERLYING CASH MARKET IS THE IMPETUS FOR INTRODUCING DERIVATIVES AND NOT THE CONSEQUENCE THEREOF EMPIRICAL EVIDENCE DECLINE .. IN .. VOLATILITY OF .. UNDERLYING .. CASH MARKET INTRN OF DERIVATIVES

SUMMING UP
A standardised forward contract is a futures contract.
Broadly, there are two types of futures, commodity futures and financial futures.

The three main types of financial futures are: equity futures, treasury bond (or interest rate) futures, and currency futures.
Equity futures are of two types: stock index futures and futures on individual securities. Both the types of futures have been introduced in India. A treasury bond futures contract is a contract for delivery in future of treasury bonds having certain features.

Futures contracts can be priced using the principle of arbitrage.

The theoretical price of the stock index futures, as well as futures on an individual stock, is: F0 = S0 (1 + rf d)T

 The theoretical price of a Treasury bond futures contract is F0 = (S0 PVC) (1 + rf)T The futures price of a perishable commodity is influenced by two factors mainly: (a) the expected spot price of the underlying commodity and (b) the risk premium associated with the futures position. Hedgers, speculators, and arbitrageurs are the participants in the futures market. Futures and options perform three very useful economic functions: risk transfer, price discovery, and market completion. There is a widespread popular belief that derivatives accentuate volatility. Many in the profession strongly disagree with this view.